May 4, 2020
Scott B. MacDonald, Ph.D
U.S. Economic Outlook — A Slow March Back to "Normal"
Summary: Coronavirus abruptly ended the longest expansion in U.S. history and things are going to get worse before they get better. This week it was reported that real GDP for the U.S. economy was -4.8 percent, the deepest contraction since 2008. Calls for a V-shaped economic recovery are getting fainter. Despite the rolling out of the CARES Act and another $484 billion in Covid-19 relief funds as well as the Federal Reserve’s raft of liquidity facilities, the recovery is going to be more painful and take longer than most Americans want. That will be seen in gruesome data releases of unemployment claims, manufacturing production and home sales. The Congressional Budget Office is calling for a 40 percent contraction in the economy in Q2, with unemployment hitting 16.0 percent. The return to “normal” is going to be slow and will mean less globalization, reconfigured supply chains, more digitalization, a bigger challenge in managing fiscal deficits and an ocean of debt — and possibly greater political risk. We have our view of where we expect the economy to head, but admit that we are humble in our forecasting. It is a challenge to get one’s arms around the enormous nature of what is happening.
First quarter U.S. economic activity was worse than many forecasters had expected. Considering the critical nature of the consumer to the economy, the Department of Commerce’s 7.6 percent decline in consumer spending from January through March provided a hint that things were going to be bad. Reflecting the dire nature of the contraction, healthcare accounts for 40 percent of the fall in consumption, with transportation, recreation, and food services and accommodation experiencing sharp declines. The current 4.8 percent contraction will likely be updated, showing a larger contraction as more data is added.
The U.S. economy is likely to see a substantial contraction in economic activity in the second quarter of 2020, but will see recovery begin in Q3 and, barring another round of the virus, gain momentum. Estimates for the year vary, with the IMF calling for a 5.9 percent contraction; Standard & Poor’s looking to -5.2 percent, Bank of America at -10.4 percent, and Wells Fargo at -2.3 percent. Smith’s is forecasting a 5.5 percent contraction for 2020, with a 4-5 percent rebound in 2021. We would add to this that different parts of the country are going to bounce back faster than others.
The problem is that the U.S. economy is being hit by a shutdown in both supply and demand. Although parts of the economy are actually experiencing growth, most of the economy has gone dormant. The world of retail has been largely closed down; many manufacturing plants are down to skeleton and maintenance crews, and demand has died – for now. There is considerable speculation that when the U.S. economy re-emerges from the recession, the consumer will be more cautious (which hurts entertainment and hospitality sectors) and more geared to saving than spending. The expected spike in unemployment has signaled for many Americans that they need to build up a cushion in their finances.
At the same time, the U.S. economy is undergoing a number of important structural changes. While the Great Recession (2008-2009) led to a critical reassessment of globalization, it was not until the Trump administration that the process of de-globalization became a core element of U.S. policy1. This was pursued by pulling out of the Trans-Pacific Partnership, using tariffs against both friends and foes on a number of products, forcing Canada and Mexico to renegotiate the North American Free Trade Agreement (now called USMCA), launching a bruising trade war with China and consistently threating a major trade war with Europe. At the same time, the aggressive stance of the Trump administration on the risks of global supply chains, many of which stretched out to China, demonstrated the problematic nature of relying too much on the outsourcing of important products, such as hospital equipment and pharmaceuticals. Part of the emerging new normal will entail the movement of production facilities closer to home, either in the U.S. or Mexico or perhaps Central America and the Caribbean. Over the long term this could help reduce the unemployment number in the U.S.
While many U.S. companies are coming to terms with the probable end of China as a global manufacturing hub, the advance of digitalization has greatly accelerated with coronavirus. This will most likely be a net gain, but there remains a considerable amount of work to be done in many sectors. This includes agriculture.
Although there are rising concerns about food security in the U.S., it is expected that some of the mismatches that occurred between production and distribution (between farms and large customer restaurants and schools or between farms and grocery stores and food banks) will be worked out. Digitalization can go a great distance to reduce the current imbalances in the food sector, though the disruption currently taking place in the agri-business and food sectors has sent a chill in American society long accustomed to access to different types of cheap food. The images are almost contradictory, U.S. milk suppliers dumping milk, while food banks are turning away people. The reality is that one part of the demand side for agri-goods has collapsed (restaurants and hospitality) and in another part (home food making) demand is up. This is a major adjustment and a greater use of technology can make a difference in getting food from the farm to the consumer more smoothly.
Digitalization of the American economy is only going to accelerate. We have witnessed a rapid increase in the use of telemedicine, tele-banking and e-commerce, distance learning as well as an advancement of usage in the 55 years and above age group. The penetration of that demographic is probably permanent and broadens market possibilities.
The other major factor hanging over the U.S. economy is the growing mountain of debt (see table below). According to the Federal Reserve Bank of St. Louis, as of year-end 2019 total U.S. federal public debt stood at $23.1 trillion (up from $19.97 trillion at year-end 2016). It is set to rise considerably following the recent stimulus packages passed by Congress. The money is needed to soften the blows from shutdowns of businesses and to reach out to millions of Americans suddenly set adrift economically. That includes many state and local governments working hard to maintain public services in the face of greater demand and lower revenue inflows.
Related to this is the widening of the U.S. fiscal deficit. According to a new projection by Moody’s, the addition of new stimulus spending on the part of the U.S. government “along with materially weaker revenues and growth” will propel the fiscal deficit from 4.6 percent of GDP in 2019 to over 15 percent this year. That means more Treasury bonds will be issued to cover the difference (one estimate put the amount at $3 trillion). It also puts more pressure on policymakers to do what they can to jack up economic growth.
Adding to the mix of things to be considered is whether the federal government, if the need arises, will be in a financial position to help bail out state governments, which of course has political implications? The political side could become more manifest if future administrations opt to raise taxes, both corporate and personal, to return public finances to a more prudent path. The other option would be to let U.S. state and local governments go bankrupt, which would raise both legal and political questions.
Along the same track of debt management, what happens to sovereign ratings? Moody’s rates the U.S. sovereign at Aaa, S&P at AA+ and Fitch at AAA. How long will it take the U.S. to bring its debt back down below 100 percent of GDP and fiscal deficit to a more manageable number? Thus far the rating agencies have been cautious, but if the recovery becomes more W-shaped or L-shaped, pressure for a downward revision could be in the cards.
Another factor that must be considered in how the economy is managed and performs is the potential for greater political risk. 2020 is an election year, which usually elevates political differences. Although the passage of large stimulus packages through the U.S. Congress reflected a high degree of bipartisan behavior, there remain very strong differences, especially around the person of the president, who is a controversial and divisive figure. There has been some discussion that in the case of a second round of coronavirus in the fall elections might be postponed. Considering that elections were held in the middle of the U.S. Civil War and both World Wars, it would be difficult to make the case; postponement could also set off social unrest. Any such unrest would certainly complicate the economic policymaking environment.
The U.S. economy is undergoing one of its worst recessions since records have been kept. Unemployment is set to skyrocket and the ranks of small and medium-sized businesses are set to be thinned. What comes out at the other end of the crisis will be different; the challenge will be to take hold of more positive trends and deepen their impact on the nation’s productivity. The U.S. will need any positive developments from the crisis to deal with the massive debt burden that has been created. Failure to find a sustainable path out of the debt could well set any recovery on unstable ground, setting the stage for another stumble, leaving the 2020s to look more like the rollercoaster-like 1930s than the roaring 1920s.
1For many critics of globalization free trade, outsourcing, and high CEO pay led to wage stagnation, underemployment, economic precariousness and record inequality in advanced economies. For the U.S. it came at the cost of losing 5 million jobs.
April 14, 2020
Scott B. MacDonald, Ph.D
Life in Times of Coronavirus
Under Pressure: Food Supplies
Summary: Since the global outbreak of coronavirus in early 2020, there has been a move to stockpile food, increase prices, and in some cases, impose export restrictions. In the U.S., as the numbers of those infected and dying rises and unemployment rapidly rockets upwards, consumer behavior has turned more cautious and food distribution centers are swamped by hungry families. This situation is not helped by the closure of restaurants and concerns over distribution systems and the health of drivers who transport food and other household items. There are also increasing questions over food cultivation and the labor needed to bring crops to harvest. Although it is too early to be sounding the alarm regarding a food security crisis, which could lead to social turmoil, the seeds for such a development are possibly being planted. The risk is the creation of a food crisis when there really isn’t one – yet. This issue is likely to become more significant if the pandemic continues through the summer, dimming hopes of economic revival and raising the specter of food shortages.
Assessing the Food Security Challenge
The food challenge revolves around supplying enough food to feed people during a major pandemic. Stated in another way, what is the balance between the actions being taken to stop the spread of the coronavirus (including the shutting down of large parts of national economies) and the cultivation and distribution of food products (which eventually means a meal on the table). While the closure of restaurants and bars has caused a disruption in longstanding food supply and demand practices, there is a growing need in other parts of society as people lose their jobs, panic-buying takes place and prices rise for some goods that have become scare.
There is a significant challenge for the work forces needed for the cultivation of food crops being able to assemble due to restrictions on labor movement (especially it involves the cross-border movement of workers). In Europe, the move to close national borders was done without much thought given to the seasonal movement of workers from Eastern Europe (Romania, Bulgaria and Poland) or North Africa (Morocco and Tunisia) to Germany, Italy and France.
Travel restrictions have reduced seasonal migration to a trickle just as farmers gear up for the harvest and just as stockpiling of food is rising. Efforts to find local workers, including students and those laid off from hospitality and entertainment, apparently have not been going terribly well. As Laura Wellesley, research fellow at Chatham House, noted (March 27, 2020): “One of the big concerns is that we will see significant labor shortages along the logistical supply chain. If we see a shortage of migrant workers, then you’re looking at a real supply shortage.”
The following snapshots provide some idea of the key role played by migrant workers in Europe’s food sector:
• In France 200,000 workers are needed in the next three months to bring in crops such as strawberries in the Loire Valley and asparagus in Alsace (according to the French National Union of Farmers, close to 800,000 are needed for the whole of the harvesting season; usually two-thirds of these workers come from abroad, including Central and Eastern Europe, Tunisia and Morocco;
• German agriculture usually takes in 300,000 seasonal workers a year from Eastern Europe, a majority from Romania as well as Poland, Ukraine, Bulgaria and Hungary;
• In the UK, some 70,000 to 80,000 workers arrive annually, many from Romania and Bulgaria to pick fruit and vegetables.
Germany went back on its initial decision that barred seasonal workers, recognizing its need. But that does not resolve the problem as Austria, Hungary and other countries have closed land borders, disrupting overland routes from Eastern Europe.
The U.S. faces the same problems. U.S. agriculture has already been struggling to meet labor needs. Zippy Duvall, the President of the American Farm Bureau Federation, noted in 2019: “Farmers and ranchers in every state tell me that the shortage of labor is the greatest limiting factor on their farms.”
Duvall also indicated that the H-2A visa program (for seasonal foreign workers) was inadequate, with 2018’s 243,000 H-2A workers filling just a fraction of the more than 2.4 million farm jobs. The U.S. agriculture labor pool has been hurt by aging, the unwillingness of many Americans to be attracted to the sector, and the Trump administration’s push to trim the ranks of undocumented workers. In response to the labor shortage and the threat from coronavirus, the Trump administration, in early March 2020, made an additional 35,000 H-2B visas available (which makes the total available this year to 101,000). There are questions as to whether this will be enough. And as with Europe, how will many of these workers be able transit to the U.S.?
Once crops are cultivated, someone needs to process them as well as get them to the market (including aircraft, ships and harbors), and once at the market destination, someone is needed to unload and make the food available. Although a certain degree of automation is used, human touch remains part of the process. Considering the pressure to impose lock downs on large blocks of populations, the delicate question presents itself – who is going to do the human part of the work in getting food to the consumer’s table?
In early April the issue of the human element became more evident, with reports of a spike in coronavirus and a small number of deaths at meat plants in the United States, including at a JBS SA beef facility in Colorado, a Cargill meat-packing plant in Pennsylvania and a South Dakota Smithfield Foods pork facility. Although the companies responded with temporary closures and cleanups, workers in some cases have threatened to go on strike unless work conditions are improved. This, of course, has an impact on consumers. As Bloomberg’s Isis Almeida and Vincent Del Giudice noted (April 10, 2020): “While it’s unclear whether the deaths and other cases have anything to do with the workplaces, the news exposes the vulnerability of global supply chains that are needed to keep grocery stores stocked after panic buying left the shelves empty.”
Large food chains (like Kroger, Target and Walmart) are stepping up to keep a steady supply of food for consumers, especially in advanced economies. Indeed, the situation is helped by ecommerce and delivery systems that bring food to the door. However, food delivery implies certain other factors – a steady supply of food, access to a computer, and an ability to pay. For those without access to the Internet at home or hard-pressed on the financial side (with a massive spike in unemployment looming), home delivery is not going to be the answer. Moreover, it still does not resolve the issue of food production and its supply chains.
While the U.S. and much of Europe are capable of feeding themselves, other countries do not have the same luxury. This is especially the case when considering two of the world’s key staple crops, wheat and rice. There are a number of major wheat and rice producers. If they close down their exports, this becomes a major problem. The table below illustrates the key relationships in the global wheat trade. Kazakhstan, a sizable exporter of wheat, in late March suspended exports (from March 22 to April 15) of socially significant food products (wheat, sugar, vegetables and sunflower seeds and oil) to guarantee domestic supply. Russia also moved to briefly suspend some key exports as did Vietnam with rice in March. Vietnam later resumed rice exports in April.
The issue facing many wheat and rice importing countries is how to do they adjust when a key food supplier is suddenly not available? Although Russia and Vietnam have resumed food shipments, if exports bans are reinstated for a lengthy period of time, there are concerns over how local populations will be fed. Major food importers like Algeria, Egypt and Indonesia have large populations and fragile medical systems, not a good combination at this juncture. Many governments (including a large number of sub-Saharan Africa) could be left trying to figure out what is the bigger problem – the spread of coronavirus or the lack of food?
One of the major concerns with food security pertains to how failures in feeding populations can result in socio-political turmoil. This has a long history, dating back to ancient periods when crops failed and populations were forced to migrate or die. Other cases involved a government’s failure to maintain the conditions for crop cultivation and distribution of food, leading to famine (a constant theme in Chinese dynastic history). Plagues have also had a similar impact on societies. Indeed, Thucydides notes that the plague which hit Athens in 430 BC led to “a state of unprecedented lawlessness…the catastrophe was so overwhelming that men, not knowing what would happen to them, became indifferent to every rule of religion or law.”
The connection between food security and socio-political stability has hardly gone away. In 2007-2008, severe droughts caused food riots in Africa. In 2010, a Russian wheat export ban resulted in food price inflation and supply problems throughout North Africa and the Middle East. In the latter case, food problems helped push the region into a wave of socio-political disruption that toppled governments in Tunisia, Libya, and Egypt and was felt in the Persian Gulf and Syria. Food has factored into riots and political unrest in other countries as well, including Haiti. Cuba also has major food security challenges, caused by a combination of decades of economic mismanagement, U.S. sanctions, and a heavy dependence on food imports.
The countries most dependent on food imports to feed their populations are generally located in sub-Saharan Africa, with the largest of these being the Democratic Republic of the Congo, Ethiopia and Kenya. Outside of Africa, the ranks of those dependent on food imports include Iraq, Syria and North Korea. One of the major worries in a number of these countries is that central authority is weak, medical systems are fragile and it will not take much to endanger food supplies.
There is some good news. Global rice inventories are close to record high and protein supplies are adequate for now. Moreover, governments and companies have been working hard to guarantee that access to food remains available. In the U.S., the corporate sector has demonstrated a solid commitment to maintaining the flow of food. More help, however, will be needed as the sting of rising unemployment has yet to become manifest in what are likely to be Depression era-like numbers. Food distribution centers are already finding high levels of demand. If nothing else, the large numbers seeking help have caught public attention and are likely to be a factor in further efforts in Washington and other capitals to meet food security challenges head on.
There is another possible scenario that could come to play, which would elevate food security concerns. What would happen if the number of deaths projected by models being used by the U.S. and other governments overestimates the number of deaths and there is a return to some type of normality? That scenario would also have to include a return to work by large numbers of people as well as advances on a preventive vaccine and better treatment protocols. If such a scenario were to unfold, the food security issue would diminish considerably. It would also do much to restore confidence in certain political leaders.
The issue that sits down the road – and concerns many governments including the U.S. – is for how long does this state of events have to be endured. Food exists now; if the coronavirus shutdown stretches out through the summer, will there be shortages of fresh fruit and vegetables? What about protein? And that says nothing to the economic carnage facing the restaurant industry. Americans have remained relatively calm for now, as have Europeans. There are not any reports thus far of largescale food riots, including in Emerging Markets. But there is a time factor at work here. A prolonged period of uncertainty over food and pandemic do not make a good combination, either for public health or the economy. There is a need for better international cooperation in both matters, while many countries will have to make a critical reassessment of their food supply security.
Most of us do not have the option of looking at the world through the perceptual lens of the U.S. baseball player, Yogi Berra, who is attributed with saying: “You better cut the pizza in four pieces because I’m not hungry enough to eat six.” At this stage, most people would be happy just to have one slice of pizza.
Photo by Estelle A. MacDonald
March 18, 2020
Scott B. MacDonald, Ph.D
The Risk of a Long Downdraft
Summary: While considerable attention is being given to the impact of the coronavirus on financial markets and resources are being marshalled to tackle the threat of a recession, the U.S. economy is being hit hard by both supply and demand shocks. Global supply lines, already disrupted by the U.S.-China trade war, have been under considerable pressure by the shutting down of China’s industrial sector, a development that has cascaded into the U.S. At the same time, the coronavirus has shut down the consumer side of the U.S. economy. Social distancing is revenue-shrinking for many companies, large and small. Important efforts are in motion to limit the downside, including the Trump administration’s stimulus legislation (ranging between $800 billion and $1.2 trillion); the Federal Reserve’s ultra-accommodative monetary policy (down to near-zero rates) and its return to quantitative easing; and the public-private effort to find a medical solution. Despite all of this, there is a risk of getting caught in a long economic downdraft — An economic reboot from both supply and demand shocks is not easy to achieve. Although we are hopeful that the U.S. recovery will be quick, the reality is that the pace of recovery could well be slower than anticipated, largely due to the effect of economic activity disruption on infrastructure throughout the country. Simply stated, as human activity is brought to a near-halt and fewer people show up to work, there are concerns about the maintenance of industrial facilities, refineries, ports, roads and public utilities. Not every job can be done from home.
China has likely gone through the worst part of the coronavirus. Their experience provides a broad idea of what might be in store for the U.S. economy:
• Industrial production contracted at the fastest pace on record in the first two months of 2020 – it fell 13.5 percent according to China’s National Bureau of Statistics.
• China’s urban unemployment rose to 6.2 percent in February.
• The Chinese retail sector is struggling. Retail sales in 2019 (with an eight percent expansion) were already weak; they plummeted by 20.5 percent year-on-year in January and February as many people were confined to their homes, shops were shut, delivery systems struggled and most consumers sought to avoid visiting public places.
• The most-hard hit in retail were restaurants, hotels and shopping malls.
• Car sales, a major retailing component, fell by 18.7 percent in January and a bruising 79.1 percent in February from a year prior.
• Online shopping was thought to be robust, though we do have data on that yet.
• What may be worth noting for the U.S. is that fixed-asset investment fell. As a Bloomberg report noted: “Infrastructure investment may have been hit the hardest of any sector, given restrictions on construction and large shortages of migrant workers. That slowdown is despite local governments issuing 950 billion yuan ($136 billion) worth of special bonds in the first two months of the year – the proceeds of which are earmarked for infrastructure spending.”
• One thing that leaped out at us was the analysis of the above by Nomura’s (a major Japanese investment bank) economists, who stated: “The contraction in FAI (Fixed Asset Investment) may be deeper than that in industrial production, as many firms may need to cut their capex to survive the epidemic.” (This could a concern for some heavily leveraged U.S. companies in the infrastructure or energy sectors).
Although China has pushed to get its factories running again, it could face a demand shock as the coronavirus is closing down both large corporate supply line purchases as well as consumer demand in Europe, Australia, Canada, Japan and the U.S. As Zhou Hao, senior emerging markets economist at Commerzbank observed (March 16, 2020): “A V-shaped recovery seems unlikely as the virus is spreading everywhere, which will pose a downside bias for external demand for China.”
The U.S. economy began 2020 from a position of strength. According to the International Monetary Fund (IMF), the U.S. economy expanded by 2.3 percent in 2019 and was set to maintain its longest expansion in 2020 at 2.0 percent and in 2021 at 1.7 percent. One of the key factors in the continued U.S. expansion was that U.S.-China trade tensions were heading toward some type of settlement with the Phase One deal. Indeed, prior to the coronavirus outbreak in the U.S., industrial production looked positive, rising 0.6 percent in February.
Coronavirus has changed the economic landscape. According to J.P. Morgan, the U.S. economy is now expected to contract at a 2.5 percent rate in Q1 and at a 3.0 percent rate in Q2, but will bounce back in the second half of the year. Goldman Sachs is calling for no growth in Q1 and a 5.0 percent contraction in Q2; it will be followed by strong growth in excess to 3.0 percent in the second half of the year.
While large companies clearly are facing tough decisions about which part of their operations to shut down (like Macy’s shutting its stores across the nation or American Airlines taking a large part of its fleet out of the air), small and medium-sized businesses are finding themselves very much on the firing line. According to Moody’s Analytics, close to 80 million jobs in the U.S. economy are at high or moderate risk, with the former (around 27 million) concentrated mainly in transportation and travel, leisure and hospitality, temporary help services and oil drilling and extraction (the last also being hurt by the Russian-Saudi oil price war that has driven oil under $30 a barrel – and falling). The remaining “moderate risk” group of 52 million jobs are in such areas as retail, manufacturing, construction and education. Still, with the massive pipeline of stimulus, the talk of a V-shaped recovery trumps the potential lay-off issue — at least for now.
We hope that these assessments of a V-shaped recovery are correct, but have some concerns that could put the recovery on a slower track and more similar to China’s. One is left wondering how much routine maintenance will occur at public utilities, refineries and key parts of the transportation system, as work forces across the country practice social distancing. How much work is going to be done on aircraft and trains that are taken out of service (and for how long)? The same question could be asked about public utilities, such as water, waste treatment, electricity generation, nuclear power plants and even roads. The longer the medical crisis extends and the deeper it bites into the day-to-day routine of the work force, the more this issue needs to be factored into any recovery.
It was Benjamin Franklin who stated, “Never confuse motion with action.” As U.S. economic policymakers prepare to deal with the negative impact of the coronavirus, they need to bear Franklin’s comment in mind. Motion will only get the U.S. economic so far; action, that includes looking at the need for infrastructure maintenance critical in re-igniting any economic engine, is also needed.
March 2, 2020
Scott B. MacDonald, Ph.D
Life During Coronavirus
Summary: It was the French philosopher, author and journalist Albert Camus who wrote that “plagues and wars take people equally by surprise.” For a global economy that was looking at 2020 as a year of gradual recovery from two years of bruising trade wars, the outbreak of coronavirus (Covid-19) in Wuhan, China has been like a dash of cold water. China’s opaqueness about the problematic nature of the disease and its subsequent spread outside of the country has decidedly come as a shock. That shock is likely to last for the next several months, with an increased chance for a global recession which the U.S. will be lucky to avoid. One reference point is the 1918-1919 Spanish flu epidemic, which took people by surprise and left an estimated 50 million dead worldwide in its wake. To be clear we do not expect a Spanish flu-like scenario; the conditions then and now are radically different, especially considering advances made in science and medicine. However, we do believe coronavirus will spread before it eventually burns itself out. Consequently, it has injected a massive dose of uncertainty into global markets as well as the daily life of many people. It is also reinforcing the trend against globalization and the fracturing of supply chains. All of this is disruptive and will take time to work itself out. As there was a beginning to the coronavirus there will also be an end. Although disruptive, there is always the other side of a crisis. And keeping one’s head is critical in finding passage through stormy waters.
The global economy and securities markets had an appalling February as reflected by the Bloomberg table above. As the month came to a conclusion, the torrent of bad news included the following:
• The World Health Organization raised its global risk level for coronavirus from “high” to “very high”. As of Friday, confirmed cases stood at over 83,000 (mostly in China), with the death toll heading toward 3,000.
• Italy has instituted lockdowns in the northern regions of Lombardy and Veneto, where it has detected more than 600 cases.
• One White House official, Mick Mulvaney, suggested some schools could close in the United States.
• In Japan, Prime Minister Shinzo Abe has closed schools for the month of March.
• Major U.S., Asian and European companies are warning that disruptions are expected to hurt sales and profit forecasts for the year.
• Alitalia announced it will extend temporary layoffs for about 4,000 workers following the coronavirus outbreak in Italy.
• Germany announced that it will intensify border checks and it has quarantined about 1,000 people.
• Switzerland banned large events, which resulted in the Geneva car show being cancelled.
• Iran and South Korea revealed more infections, while the first cases appeared in Mexico and Nigeria. The latter is Africa’s most populous country and its healthcare system is likely to struggle with the virus.
• The virus has also reached Brazil and it is felt that other countries in Latin America and the Caribbean are vulnerable.
• According to Wilshire Associates, U.S. shareholders were down $2.8 trillion last week and $4.6 trillion from the February 17 high. (This should be seen in the light of U.S. shareholder gains have been cut since the Christmas Eve 2018 to $6.3 trillion from $10.9 trillion.)
• Brent crude dipped below $50 a barrel for first time since December 2018.
• Most major economists are downgrading global growth for 2020. Bank of America predicted that the global economy will see its weakest year since the financial crisis in 2008 as the virus weakens demand in China and beyond.
It is very easy to get caught in a negative swirl of announcements. The coronavirus makes a very compelling story – it emerged behind a wall of Chinese secrecy, quietly spread out from the epi-center in China and is now enveloping the world. The step-by-step approach of the disease is, by any consideration, scary.
What to take from all of this?
1. The global economy, which was already fragile from two years of bruising trade wars, is likely to take a major hit. This is due to the fact that China accounts for 20%-22% of global GDP and is a major trade partner for most of Asia, Japan, Europe, Russia, and Latin America. Most of China’s industrial base has been taken offline as the authorities grapple with containing the virus through quarantine. Restarting the industrial engine will take time. China’s manufacturing activity in February plunged: the country’s manufacturing purchasing mangers’ index fell to 35.7 percent, an all-time low and down from 50 in January. In the meantime, ships with goods remain offshore of China or are finding other markets. This is the case for Chilean and Peruvian copper and other commodities. The ripples from China’s shutdown reach into the U.S.; one need only to read the recent quarterly reports of Disney, Starbucks, and Nike and look at their stock prices.
2. Markets hate uncertainty. The coronavirus clearly represents a major X-factor that is difficult to quantify. Moreover, the cutting of interest rates (which the Federal Reserve is likely to undertake in March 2020 does not necessarily resolve the issue). Monetary policy tools may serve as a remedy to many things, but there are not going to be a substitute for a medical cure. That uncertainty is likely to continue until a remedy is found and the rate of infectious cases falls.
3. Markets are also nervous about the state of U.S. politics. The rise of Bernie Sanders as the leading candidate for the Democratic ticket has certainly added an element of concern for investors. Sanders’ outright disdain for capitalism, dislike of entrepreneurs, his admiration for communist systems (he honeymooned in the Soviet Union and admires the Cuban Revolution), and impassioned advocacy for raising taxes on the wealthy and middle classes and spending huge amounts of money (without any idea of exactly how much) has left investors cold. Moreover, if the Democratic convention is brokered, Sanders could obtain his candidacy by reaching a pact with Senator Elizabeth Warren (perhaps even as a vice presidential candidate). While this leaves room for a re-run of the UK elections, in which a nationalistic Conservative Boris Johnson trounced hard-left Labour leader Jeremy Corbyn, a coronavirus-induced recession in the U.S. could instead open the door for a Sanders presidency. Of course there is considerable ground to be covered between here and the November election, but a Sanders candidacy has become more of a possibility after Iowa, New Hampshire and Nevada and could gain momentum if the U.S. economy sinks.
Looking ahead: The way forward is challenging. We need better clarity on outcomes with the coronavirus and, most of all, we need a vaccine. The sad fact is that the sooner the virus burns its way across the planet, the faster things will return to “normal”. We put normal in quotes as the new normal is a reduction in globalization, meaning less trade, travel and mingling both cross-border and within borders (at least for the short term). It will also be defined by manufacturing closer to home (which could result in higher costs of production which will be passed on to consumers), a larger role for alternatives to China in the global supply chains that remain (good news for Vietnam, Thailand, Indonesia and Malaysia), and major adjustments in certain business sectors (airlines, cruise ship lines, transportation and entertainment). Commodities are also going to struggle in the face of a stronger dollar and falling demand (driven by a major slump in China demand). Anyone in mining is looking at a bruising 2020.
The high yield bond market is particularly vulnerable to an extended disruption in markets. According to EPFR Global data, investors pulled $6.8 billion from mutual funds and ETFs that invest in high-yield bonds in the week ending on February 26th. This included a total of $4 billion pulled out of BlackRock’s flagship high-yield ETF, HYG, and State Street’s JNK, which lost $1.2 billion in redemptions. The high yield energy sector is expected to see turbulent times ahead as many companies are already highly-leveraged and oil prices are down, reflecting slower economic growth prospects. For the high yield bond market this is bad news, considering that energy companies make up the bulk of debt in the broader high-yield bond market and comprise 13 percent of bonds rated triple C.
Governments face some tough decisions. While central banks can maintain their support in terms of monetary policy (with some analysts calling for three cuts from the Fed this year), the real action rests with governments. How do they respond to a spreading coronavirus? There is a fine balance to be walked between transparency and disclosure and starting a panic. What stimulative measures can be put in place? Many countries are already running sizable fiscal deficits and have jacked up their debt in recent years (like France, the UK and U.S.); will there be ratings implications?
And how can this be coordinated internationally? In this Europe is in bad shape since the Germans remain resistant to fiscal stimulus, which has a major impact on all of the Eurozone. Indeed, Germany and Italy are highly likely to tip into recession in 2020. Add to this the uncertainties around Brexit, the lingering potential for a trade war with the U.S., a major reduction in Chinese demand for European goods, and the absence of Chinese tourists. Japan is also heading into recession. Relations between Russia and the West are not exactly warm and fuzzy, while Russia has closed down its border with China.
In 2008, the G20 group of nations (the world’s largest economies) were able to coordinate economic policies to prevent a sustained global economic downturn. Any similar coordination is likely to be that much more difficult, considering the acrimonious trade wars of the past two years. However, if the coronavirus deepens as a crisis, national interest may dictate a more coordinated approach for all countries. Perhaps the words of U.S. science fiction writer, C.J. Redwine are most apt for anyone looking at the situation: “Losing your head in a crisis is a good way to become the crisis.”
February 18, 2020
Scott B. MacDonald, Ph.D
Outlook 2020 Series, No. 5
Beyond Brexit — The UK Ship Has Set Sail
Summary: For 47 years European Union (EU) membership defined the UK’s relationship with the rest of the world. Now, the UK ship has set out onto the choppy waters of the global economy alone, seeking to redefine itself. That task will hinge on the ability of the Johnson government to revive the economy, while healing some large rifts in British society over Brexit. It will also require the UK to forestall, if possible, a new Scottish independence referendum until economic growth kicks in and reconstruct a framework for London’s relationship with Brussels and the rest of the world. This is not going to be an easy process and much will depend on the ability of Prime Minister Boris Johnson to maintain the momentum he gained by his party’s victory in the December 2019 general election. To achieve the Brexit dream of creating a “Singapore on Thames”, Johnson will need stamina, luck and boldness. He should also heed the words of Winston Churchill, “Success is not final, failure is not fatal, it is the courage to continue that counts.”
The December 2019 general election, which left the Conservatives with an overwhelming majority of 365 seats (a gain of 48), was a major turning point in British politics for two reasons – it gave the government a clear majority, backed by a popular vote, to trigger Brexit and it reconfigured UK politics with large numbers of former Labour supporters turning to the Conservatives for the first times in many decades. This is important. What comes next is likely to determine whether the United Kingdom remains united or becomes Little England (marked by the departures of Scotland and possibly Northern Ireland).
Most British were deeply frustrated by the inability of Theresa May’s Conservative government (2016-2019) to break the impasse on what direction to take in terms of a hard or soft Brexit. Despite Prime Minister May’s efforts to reach agreements with the EU, her plans were repeatedly voted down in parliament, in part due to an inability to maintain Conservative Party unity. Consequently, parliament was able to block any movement forward on Brexit, but was equally unable to provide resolution. Her resignation allowed the rise of Johnson, who promptly purged the Conservative ranks of remainers and made the Tories the Brexit party (as opposed to the Brexit Party). In this capacity he gave the British electorate a stark choice between leaving and Labour’s fuzzy offer to perhaps hold another referendum. Labour lost 60 seats, suffering its worst loss since 1935.
The 2019 election reflected another development — it was a protest by many “left behind” communities, who never benefited in the go-go years of late Thatcher-Major and Blair governments. While London and the south did well economically, much of the Midlands and north remained an industrial rust belt. Much of this region also felt disadvantaged by the UK’s membership in the EU, which many blamed for their loss of economic livelihoods and “out-of-control” immigration.
In the December election, much of this region flipped from long periods of support for the Labour Party, turning to the Conservatives who were promising to leave and “level up”. The latter term means to upgrade the standard of living for a large swath of the country, by investing in infrastructure and seeking to make local areas more attractive to investment. It also means leveling up that part of the UK economy to London and the south.
One option for the UK to finance a leveling up policy is to borrow. The UK has done a solid job of fiscal prudence over many challenging years on the growth front (in this the uncertainty over Brexit came close to stalling economic expansion). While the UK’s gross government debt to GDP is high, it is lower than Belgium (101.2%), Italy (133.7%), France (99.3%), Japan (236.1%) and the United States (106.2%). This will have to be carefully approached but it is likely that there would be an appetite among global investors for UK sovereign debt, especially as the country’s interest rates are not negative. If the government can stimulate the economy, prospects for growth are likely to improve, especially once new trade rules are hashed out with the EU and other countries. This is a critical element in making Brexit work and keeping the United Kingdom whole.
The leveling up policy means a more active state role in the economy, which is likely seen as a necessary evil by Johnson, who decidedly is a capitalist. The paradox of this was captured by the Financial Times’ editorial board (January 31, 2020): “The vision of a buccaneering, free-trading, lightly-regulated UK championed by Brexit’s intellectual fathers must be squared with the more state-led stance the government has flagged.” This will be one of the tests waiting for Prime Minister Johnson.
Trade policy is going to be a tough challenge and the loss of a free flow of trade, referred to as “frictionless”) with the EU (including Northern Ireland) is going to cost British business. In early February there was a setback in this as Cabinet Minister Michael Gove admitted that a new “smart” border to cut post-Brexit trade friction with the EU will not be ready until 2025. Gove told the freight industry to prepare for new bureaucracy and costs from January 1, 2021 when the post-Brexit transition period ends and the UK leaves the EU customs union and single market. This means that the UK will introduce import controls on EU goods, with both sides of the border collecting customs, value added tax and excise duties and checking the safety of goods crossing the border, which prior to this was friction-free.
This also raises major issues for Northern Ireland, which shares the UK’s only land border with the EU (though the Republic of Ireland). Northern Ireland is a complicated issue: EU membership helped stimulate economic growth, which helped reduce political animosities between the Protestant majority and Catholic minority and dampened support for the violence of the Irish Republican Army in their campaign to force the British out and force unification. The February 8, 2020 election in Ireland might have possibly brought the former civilian political wing of Sinn Féin, whose platform advocates for unification with Northern Ireland. There is deep concern on both sides of the Irish border that the imposition of a hard border will stall economic growth the rekindle old political passions.
Another task ahead for Prime Minister Johnson also includes keeping Scotland in the Union. This could be a challenging task considering the northern part of the island of Great Britain voted overwhelmingly to remain within the EU. Scotland already has an independence movement which holds a majority in the Scottish Parliament. Elections for the Scottish Parliament are set for 2021. They could provide a political springboard for the Scots if the SNP wins an overwhelming victory at the polls. However, the leveling up policy could have an appeal to lower income groups in Scotland; any erosion in this group’s support for the SNP could make a difference in the 2021 Scottish elections.
The 2016 Brexit Vote
In the months ahead, the UK and the European Union will have negotiations over finding a working trade agreement. They have until the end of the year to find accommodations that both sides can live with. This could be complicated by a Scottish push for a new referendum on Scottish independence and EU encouragement for Edinburgh to join Europe. This issue has already surfaced with the recent comments of former European Council president Donald Tusk, who stated that he feels “very Scottish, especially after Brexit.” When asked about the prospect of an independent Scotland joining the EU, the Polish politician stated: “Emotionally I have no doubt that everyone will be enthusiastic here in Brussels, and more generally in Europe.” This comment set off rumblings of Europe not respecting British sovereignty.
A trade deal with the United States represents a considerable opportunity, but it also has risks for Prime Minister Johnson. Although there has been a certain chumminess between President Trump and Prime Minister Johnson, the U.S. leader and his team see trade as a win or lose game in which they will seek the maximum of what they can extract even if it erodes the UK’s National Health Service to advance gains for U.S. big pharma. To remain in office Johnson has to remain true to core British interests, which include maintaining the integrity of the NHS. Failure to do so would erode support among new Conservative voters in lower income areas in the north and Midlands as well as stir dissent within his own party. Johnson is keenly aware that a prime minister who loses his or her support within the party can be toppled as was the case with Margaret Thatcher in 1990 or Theresa May in 2019 (who against Johnson launched his own party coup). We expect that trade talks between the British and Americans will be a tough affair.
The UK is a AA-rated sovereign credit. Currently Moody’s and Fitch have negative outlooks due to concerns over rising debt and political paralysis. Our outlook is negative, but we are cautiously optimistic that post the December 2019 election, the British government has broken through policy paralysis. While we do have concerns about prospects for a rise in debt, that view must be balanced with a consideration that if economic expansion resumes at a stronger pace, debt levels could fall over the longer term.
Looking ahead: As has been said by many pundits — the UK has achieved Brexit; now comes the hard part. The agenda is full, including hammering out a deal on trade with the EU, how to satisfy Scotland enough to remain in the Union, what to do with Northern Ireland (which is part of the UK but will be under EU trade rules through 2020), and when to engage the U.S. in trade negotiations. We hope that Prime Minister Johnson is a good juggler as he has plenty to juggle.
January 28, 2020
Scott B. MacDonald, Ph.D
Outlook 2020 Series, No. 4
China and Coronavirus
– The Year of the Rat is Going to be a Challenging One
Summary: The Year of the Rat is off to a bad start for China. The world’s second largest economy and home to its biggest population is being whipsawed by an outbreak of the coronavirus. As of the end of January, China confirmed over 2,000 cases and close to 100 deaths and climbing. More than 60 million Chinese now have their movement restricted. Although the virus is being downplayed as a short-term risk to markets and the global economy, investors in global markets have pulled back (at least for now), growth prospects for a number of countries are being reassessed, and oil prices have been pummeled, tumbling to their lowest prices in more than three months. Although there is considerable talk that markets are over-reacting, the coronavirus represents uncertainty. Fortunately earlier disease challenges have been contained, such as SARS and Ebola (out of West Africa). We expect this crisis to get worse before it gets better, but it will eventually be contained. That said, its impact threatens to dampen global growth and could have long term implications for China’s ruling elite.
Coronavirus and China: The coronavirus is of the same family as severe acute respiratory syndrome or SARS, which killed more than 900 people during an outbreak that began in 2002. The new virus is thought to have been originally transmitted from an animal in a wildlife food market in Wuhan, one of China’s largest cities (11 million people). The first case occurred in late December.
Patients infected with the coronavirus usually demonstrate symptoms such as fever, cough and breathing difficulties. SARS had a fatality ratio of 11 percent of those infected; the new coronavirus appears less deadly. Local authorities in Wuhan may have initially downplayed the impact of the virus, but as deaths mounted and it spread throughout the country then jumped international borders (with confirmed cases in Australia, other parts of Asia, Europe and North America), the central government has stepped up its efforts to deal with the situation.
Part of the problem facing China and the global community is that accurate numbers of those infected by the coronavirus are hard to calculate. People can be infected with the disease, but it may take several days before the symptoms become evident. According to Chinese authorities, an estimated 5 million people left or transited through the greater Wuhan area before travel restrictions were imposed. Another factor is that the Chinese authorities are not always open about bad news, though there seem to have been improvements since the beginning of the outbreak.
Among actions taken by the government are the sending of army doctors into some of the most infected areas to help local hospitals and the deployment of military personnel to enforce travel restrictions in parts of the country (14 cities are in lock down). Other measures include: the closure of movie theaters; Disney’s shutting down of its mega theme park, the Shanghai Disney Resort; and the closure of many other public venues like the Forbidden City, Beijing’s Bird’s Nest Stadium and the Ming Tombs. The closure of movie theaters is significant; the Chinese New Year period usually brings in well over $1 billion in box office revenues and seven major blockbuster releases were postponed.
Another action undertaken by China’s Ministry of Culture and Tourism is to order travel agencies and tourism companies to stop selling tour packages. As the Chinese have become more affluent, they have joined the ranks of world travelers. For anyone keeping an eye on the spread of the coronavirus, those countries with the largest visits by Chinese tourists, businesspeople and students have something to watch (see below). Hong Kong is on high medical alert.
History is filled with past misadventures with disease. While the current outbreak is not on the same scale or as deadly, William Rosen’s seminal book, Justinian’s Flea: Plague, Empire and the Birth of Europe, is instructive of the 6th century path of the plague out of Egypt and into the rest of the Mediterranean: “The disease that appeared in the 540th year of the Common Era was lethal – seven in ten victims died within a week – but it was containable. Like a fire in the middle of a desert, and in fact like every earlier disease outbreak in human history, the pestilence would soon burn itself out for the lack of fuel…or, it would have but for one thing. One hundred and sixty miles to the west of Pelusium, on the other side of the Nile delta, was its much larger cousin, Alexandria. Once the pestilence migrated across the delta, it found a huge new fuel source in the hundreds of thousands of residents of the Mediterranean’s second largest city. And, far more dangerously, it found the ships.”
The description of the plague’s outbreak in sixth century Egypt is chilling. China’s problem with the coronavirus is not of the same size and scale, but it is spreading and China’s 1.3 billion population offers plenty of fuel for the virus. And China is more connected before now than in 2003, when the country experienced the SARS virus.
Rosen made another point in his book Justinian’s Flea; the devastating impact of the plague changed the balance of power in the sixth century Mediterranean. Until that point the Byzantine Empire had been on the rebound, reconquering parts of the old Roman Empire. The plague gutted imperial power, leaving a weakened military entity when Justinian died, eventually to be radically shrunk by the power of the Arabs and Islam in the seventh century. Although the dynamics of regional power are very different, a mishandling of the coronavirus could weaken President Xi’s position or lead to unrest.
Which parts of the global economy are most exposed? Front and center, China’s economy is going to be hurt by coronavirus. Billions of dollars of business have already been lost in retail, travel and entertainment. If the disease sticks around for the next couple of months, it could also filter into manufacturing and technology. According The Economist Intelligence Unit, if the coronavirus becomes as dangerous as the SARS outbreak, it could have a major impact on China’s economy, possibly cutting 0.5-1.0 percent in total. In early January, before the outbreak, the IMF forecast 6.0 percent real GDP expansion for China in 2020 and 5.8 percent in 2021. Shave off 1.0 percent of growth and China is looking at 5.0 percent growth, which would be a major problem for the Xi government.
The immediate knock-on effect hits much of Asia. Considering proximity and frequency of tourist, student and business travelers from China as well as trade and foreign investment out of China (including through the Belt and Road Initiative), countries like Japan, Thailand, Indonesia, Malaysia, South Korea and Singapore are on the receiving end. Hong Kong and Macau have been significant destinations for mainland Chinese travelers, especially during holidays. Europe is exposed on this front with Italy, France and Germany representing sizeable tourist flows and trade. The U.S., which is one of China’s top trading partners, will also be affected, though not on the same level as the Asian neighborhood.
The business sectors most impacted by the coronavirus outbreak are airlines, shipping companies, luxury goods companies, tourist firms, and hotels. Some of the non-Chinese companies being hit hard are Nike, Starbucks, Estee Lauder, McDonald’s, and Yum Brands. Oil prices have also been pummeled by the coronavirus with the view that it will slow Chinese economic growth, which will translate into less demand for energy.
The global luxury trade has benefited substantially from globalization and the rising affluence of Asia, in particular from China (see table below). Indeed, the luxury trade has weathered the ups and downs of the global economy. However, China’s newest disease has interrupted the Chinese Lunar New Year, a time when expensive gifts are bought and expensive trips are more frequent. This season is now expected to be a wash. If the coronavirus lingers, it could be even more of a setback to luxury sales, which will squeeze a number of companies on the profit front.
The significance of the top-end Chinese consumer should not be underestimated. Luxury companies have become dependent on the Chinese big spenders. As Bloomberg’s Andrea Felsted noted (January 24, 2020): “Shoppers from the world’s most populous nation, be they in Shanghai, Singapore or San Francisco, probably account for about 35% of global luxury goods sales last year…What’s more, they generated the lion’s share – 90% of all growth.”
Looking ahead, the consequences of the coronavirus for China are potentially worrisome. A lasting pandemic could cut into the country’s economic productivity, stall its movement of goods and taint China’s name and goods in the rest of the world. At the same time, it could badly erode the legitimacy of the Communist government with its citizens, setting in motion social unrest and a possible wave of repression. If nothing else, the coronavirus could humble President Xi and weaken him politically. China needs to gain better control over its public health, devolve some authority to local authorities to take greater initiative on dealing with such matters (clearly the mayor of Wuhan and his associates fell down on the job), and demonstrate a greater degree of accountability to its public.
The response to the current medical crisis has probably been better than the SARS outbreak in 2003, but more Chinese travel today than ever before. China is beginning 2020 with a tough new test. Hopefully for the rest of Asia and the world, China is up to the challenge. If not, the ripples effects of the coronavirus are likely to spread outward, acting as a brake on global economic growth. Such a slowdown would most likely not be recessionary, but it will still be felt around the world. Let’s hope the Year of the Rat gets better.
January 21, 2020
Scott B. MacDonald, Ph.D
Outlook 2020 Series, No. 3
Phase One – the Pause that Refreshes
Summary: It was Charles Maurice de Talleyrand, one of Europe’s diplomatic masterminds and a survivor of the French Revolution and Napoleon Bonaparte’s rise and fall, who stated: “Speech was given to man to disguise his thoughts.” Talleyrand would have enjoyed the pomp and ceremony surrounding the signing of the Phase One trade deal between China and the United States at the White House on January 15, 2020. There were a lot of speeches talking about the new and improved Sino-American relationship, but the decoupling of the U.S. and Chinese economies is still in motion. Phase One is a truce in a much longer struggle for global mastery between the world’s two major powers, the United States and China. There are serious questions as to whether Phase Two will ever be negotiated to the satisfaction of either party. And it is likely that both President Donald Trump and his Chinese counterpart, Xi Jinping, know this.
Five key areas stand out in Phase One:
• China has committed to increasing its U.S. imports by at least $200 billion over 2017 levels, raising purchases of agricultural goods by $32 billion, manufacturing by $78 billion, energy by $52 billion and services by $38 billion.
• China has agreed to make a greater effort against counterfeiting and make it easier for companies to pursue legal action over copyright theft.
• The U.S. will maintain up to 25 percent tariffs on an estimated $360 billion of Chinese goods; China has levied new tariffs on $100 billion worth of U.S. products and is expected to maintain most of them.
• There is language that addresses competitive currency devaluation, indicating that both countries reserve the right to request the International Monetary Fund (IMF) to intervene.
• China agrees to remove barriers to help U.S. banks, insurers and other financial services companies to expand into the Chinese market.
Phase One is a truce, a badly needed one for Presidents Trump and Xi. For the former, the trade deal allows him to campaign for re-election having promised to act tough with China and produce an agreement that levels the playing field (or at least reaches in that direction). The Democratic presidential candidates are all critical of the deal, but none of them has anything much better to offer at this point. Moreover, the U.S. economy has remained strong throughout the trade war, with real GDP hitting 2.9 percent in 2018 and 2.4 percent in 2019, which gives the U.S. leader another plus factor in what is likely to be a nasty presidential campaign.
For Xi, the trade deal is highly important. Unlike the American president whose economy expanded through the trade war, the pace of Chinese real GDP growth slipped from 6.8 percent in 2018 to 6.1 percent in 2019 and is set to dip under 6.0 percent in 2020 (according to the IMF). Although some of China’s slowing in economic activity can be said to have come from structural reforms, the cooling in trade clearly hurt.
And President Xi faces other factors, ranging from an outbreak of African Swine fever (ASF), which has culled close to half of China’s hog herd and is putting pressure on inflation from rising food prices, to environmental problems pertaining to breathable air and clean water. The ASF issue is a worry, considering that pork has long played a central role in Chinese cuisine. The current situation is also putting upward pressure on food prices, which, if unchecked, could raises worries over public discontent. President Xi’s other headaches are the pro-democracy movement in Hong Kong and Taiwan, where President Tsai Ing-wen, the pro-independence leader, easily won re-election in early January 2020. Phase One gives Xi a badly needed truce in an area critical to China — trade.
The Phase One trade deal is also important for the rest of the global economy. According to the IMF, global trade cooled due to the Sino-American trade war (and other trade disputes): the world’s real GDP growth rate dropped from 3.8 percent in 2017 to 3.0 percent in 2019. One of the most hurt regions was the Eurozone, which saw real GDP growth slip from 2.5 percent in 2017 to 1.1 percent in 2019. Consequently, the Phase One trade deal injects confidence that the globalized structure of trade is still partially intact, hopefully enough to keep world economic growth afloat.
Phase Two represents a much more difficult challenge. The Phase One document is 86 pages, considerably shorter than the 150-page document that was gutted by hardliners in Beijing in May 2019. This because many of the structural issues were left for later. While Phase One pulled China and the U.S. back from a more damaging breakdown in trade (which would drag the rest of the global economy along with it), the issues left off the table are perhaps beyond finding accommodation.
Phase Two touches upon the core of the Chinese development model, “market-Leninism”. This is a market-based economy with a heavy state role, but with a sizeable private sector (though Communist Party officials are likely to be embedded in the management structure of key companies). Moreover, China’s long-term goal is to take the commanding heights of the global economy, which means gaining cutting edge technology in such areas as AI, facial recognition, space travel, and 5G. Huawei, the Chinese multinational technology company, looms large in this. As the development of these technologies is costly, the Chinese state has been willing to provide low-cost loans and provide preferential treatment in obtaining contracts. Even with the signing of Phase One and Phase Two, SRG does not believe that China is giving up its aspirations of world dominance.
In addition to the very different approaches to each country’s economies, China and the United States face a number of potential geopolitical flashpoints. These include China’s push to assume control of the South China Sea; U.S. support for Taiwan, which Beijing sees as a “breakaway province”; American sympathy for the pro-democracy movement in Hong Kong; the Belt and Road Initiative in Eurasia and its extensions into the Caribbean and Latin America (including Cuba and Venezuela); and China’s willingness to trade with Iran. Cyber-hacking also fits into the context of the relationship, especially as Chinese hacking is thought to have hit such targets as the U.S. government (including military organizations), major corporations and state governments.
There are two last points worth considering that point to the tough path for any Phase Two deal. First, some tariffs are likely going to remain in place over the long term (there will be no return to conditions prior to the advent of the trade war). The strategic decoupling of the world’s two largest economies is likely to be a long term process, but controlled by some mechanisms such as trade deals, like Phase One. No one wants a complete breakdown, but the Trump administration has sought to create a more level playing field and called many Chinese practices into question. The second point is that most of the rearrangement of global supply chains away from China by U.S. companies that has already occurred is likely to remain in place. Conversely, there is a greater sense of urgency in China to be less dependent on U.S. technology.
Despite the major questions over a Phase Two deal, the Phase One trade deal is a net positive. It is important to note that many U.S. companies remain committed to being in the China market and Chinese companies are of the same mind about being in the U.S. market. The new deal provides greater clarity as to the rules of the game, which is important at this juncture. Perhaps the words of the American writer, Steve Maraboli, are most apt: “It’s a lack of clarity that creates chaos and frustration. These emotions are poison to any living goal.” If the goal is a more equitable trade relationship, then the Phase One deal provides a more user-friendly structure – at least for now.
January 9, 2020
Scott B. MacDonald, Ph.D
Outlook 2020 Series, No. 2
Will Food Prices Be a Spoiler for the Global Dinner Party?
Summary: One of the most famous sketches by the British comedy group Monty Python involves a man who is being questioned incessantly by an annoying person and finally says that he did not “expect a kind of Spanish Inquisition.” Upon that statement a group of men dressed in 15th century Spanish Catholic robes storm into the house and proclaim, “Nobody expects the Spanish Inquisition!” The same could be said for a shock to global food prices, nobody expects food price inflation! However, one of the potential risk factors for 2020 could be stealth inflation in food prices, caused by a combination of factors, including the spread of African Swine Fever (ASF), swarms of locusts, droughts and massive fires. This raises major questions for economic policymakers as well as investors throughout the world’s largest economies and countries; how prepared are they if food prices spike? The answer is probably that they are not.
Food prices have been on the rise through the second half of 2019, reaching levels not seen since 2017. The drivers have been greater demand for sugar and key cereals and meat. In its November price read, the Food and Agriculture Organization (FAO) noted: “The FAO Meat Price Index averaged 190.5 points in November, up 8.4 points (4.6 percent) from October, representing the largest month-on-month increase since May 2009…Price quotations for all types of meat represented in the Index firmed, with those of bovine and ovine rising the most, reflecting tight export availabilities against persistent strong import demand, especially from China.” The reason for higher demand out of China is directly related to the spread of ASF.
ASF originated in Kenya in 1907 and has since seen periodic outbreaks (contained by culls), hitting parts of Europe and the Caribbean (Hispaniola) in the 1980s. Eastern Europe has been fighting ASF since 2014 when it first spread from Russia. Over the last two years it has headed east and in 2019 the disease did considerable damage to China’s stock of pigs and hogs. Indeed, the disease has reduced the country’s pig herds by over 40 percent due to mass culls designed to stop it spreading further. The resulting shortages have seen pork prices more than double. According to China’s National Bureau of Statistics, pork prices rose 110 percent from a year ago in November 2019. This followed a 101 percent increase in pork prices in October.
The situation was exacerbated by criminal groups seeking to take advantage of the situation by spreading the disease to cause a panic among farmers, forcing them to sell their livestock at discount rates. What has made this worse is that once the gangs get the pigs, they smuggle the animals or their meat to other areas where prices are higher, despite a ban on transporting pork or livestock between the provinces to control the disease’s spread. And ASF is spreading, according to reports from Korea and Vietnam. To make up the difference many countries are forced to turn to imports.
The Chinese authorities have downplayed the importance of ASF and indicated that pork prices have recently fallen. While Smith’s Research & Gradings questions that assertion, we know that the Chinese are importing other meats to compensate for the loss of pork. One result of ASF and the related heavier Asian demand for protein is greater demand for U.S. meats. As The Philadelphia Inquirer’s Lydia Mulvany and Deena Shanker noted (December 16, 2019): “While the United States is seeing record meat supplies, demand has started to show signs of picking up. Ham prices are near seasonal records amid a frenzy in overseas purchasing, lifting pork values.”
Pressure is also growing on alternatives to pork. Companies such as Springdale, Ark.-based Tyson are reporting “extreme” interest in chicken from Chinese buyers after a multiyear ban on U.S. chicken ended. Those sentiments were echoed by U.S. chicken producer Sanderson Farms, which stated in its Q4 2019 earnings call with an eye to 2020: “The protein deficit caused by African swine fever in China and other countries, recently well-publicized chicken sandwich features at quick-serve restaurants, and expected higher retail pork and beef prices should all support poultry markets as we move into 2020.” (The protein deficit caused by China and ASF is beginning to help U.S. meat prices, which have been hurt by too much supply.)
While China has sought to play down ASF and some analysts point to the lack of other inflationary pressures in the Chinese economy, global demand for protein may be hit by another area of ASF outbreak – Germany. For a country with a deep cultural love of sausages, an outbreak of ASF is being closely monitored, especially as it was detected in Belgium in 2018 (among wild boars) and more recently in Poland and Slovakia. As Germany accounted for 15 percent of the world’s pork exports in 2017, an ASF outbreak here could exert greater pressures on this white meat. The U.S. and Canada are taking measures to prevent an outbreak. Denmark has even built a fence along one border to keep out infected pigs.
While much of the discussion has been about the impact on consumers of pork, the spread of ASF could impact the global business, worth an estimated $28.5 billion in exports in 2018. Loss of those exports would certainly have ramifications for local economies. The U.S. is the world’s largest pork exporter, accounting for 16.2 percent of total world pork exports, followed by Germany (15.5 percent), Spain (12.2 percent), Denmark (9.2 percent), and Canada (8.5 percent).
But African Swine Fever is not the only problem bugging food markets. In parts of Africa and South Asia, locusts are ravaging foods crops. As the Financial Times’ Anjana Ahuja (December 17, 2019) noted: “In recent months, swarms of locusts have been tearing through parts of the global south. In the northern Ethiopian state of Amhara, they have devoured virtually all the crops and are now threatening neighboring countries, including Eritrea. Ethiopian swarms are also merging with swarms from Somalia in their hunt for new pastures.”
FAO Locusts Situation & Threat Map
Problems have also occurred along the India-Pakistan border, which raised some major concerns over food security in those countries. In India, the problem has been most marked in Gujarat, where locust swarms were the worst in 25 years, causing considerable damage to food and other crops. In Pakistan, locust swarms devastated parts of the south, hitting wheat, cotton and vegetable crops. Although the FAO indicated in early December 2019 that the situation in both India and Pakistan was being brought under control, this was the worst infestation since the 1990s, with a swarm descending on the Pakistani port of Karachi for the first time since the 1960s.
The locust issue should not be downplayed. According to the FAO’s Desert Locust Information Service, locusts can fly more than 100km a day (about 60 miles), stripping vegetation as they go. A swarm can take up as much as several hundred square kilometers, with up to 80 million insects in each square km. What is now a problem for Ethiopia, Eritrea and Somalia can become a problem for South Sudan, Sudan and Kenya. Indeed, the locust swarms in Ethiopia and Pakistan are thought to have originated in Yemen, where conflict destroyed local monitoring equipment and ended control efforts. The FAO is projecting locust swarms will be heading to southwest Pakistan and Iran in the upcoming months. That could portend food concerns for both countries.
Some Geopolitical Considerations
Food security and inflation in food prices have a number of knock-on effects, which could become more manifest in 2020. We would include the following:
• Chinese companies may become more aggressive in buying Western food companies or purchasing agriculturally productive land. The world’s largest pig and pork producer in the world, Smithfield Foods, is already owned by WH Group of China. Other wealthy countries, such as those from the Gulf States have in the past been active in buying agriculturally productive land in parts of Africa.
• Ongoing drought in eastern Africa, southern Africa and the Horn of Africa pushed up food prices in 2019 and is expected to be a factor again in 2020, raising prospects for greater migration and conflict. This could fuel migration problems, inject political instability and put pressure on already challenged infrastructure.
• Tensions are already high between Egypt and Ethiopia over the latter country’s construction of a massive dam complex, the Grand Ethiopian Renaissance Dam. Egypt and Sudan, which depend on the Nile for food cultivation and water use see the dam as a threat to their water security. The countries are in talks, but this remains a potential flashpoint.
• India has severe water problems: in 2019 large parts of the country saw the worst drought in decades. The reasons vary between poor water management to problems with the monsoon rains not showing up in the same quantity as expected. According to the World Resources Institute, 54 percent of the country faces high to extremely high water stress. The Indian government claims that 600 million Indians are facing acute water shortages, which means that the average household of four people in some parts of the country must have water delivered, giving it 590 liters for a week, sometimes longer. (In Singapore, water usage is more than 140 liters per person per day).
Looking ahead into 2020, food security is likely to become a more pressing issue. Directly related to scarcity is the potential for increases in food prices. There will clearly be winners and losers in this – for countries like the United States, Canada, much of Europe, and Brazil their products will be in demand – trade wars or not. For countries like China, India, Egypt and Pakistan, the price of food has significant consequences, both economically and politically. The most likely push is for a gradual upward movement in food prices (something which the USDA is calling for in the United States in 2020). Indeed, global growth rates remain relatively tame and inflationary pressures are generally flaccid (see table above).
However, a daisy-chain of developments could change that. The 2011-2012 period demonstrates how this can occur. According to the World Bank, wheat prices more than doubled in 2011, partially due to massive wildfires that devastated Russian crops in 2010. In response to that, commodity speculators drove prices higher, hitting corn, sugar, and cooking oils. On top of this droughts in the southern U.S. reduced hen output, raising egg prices. Pressure on food prices carried into 2012 as transport costs rose related to threats of military actions against Iran and high demand for oil for summer vacation driving.
It is highly unlikely that the same chain of events would re-occur in 2020. However, an alternative daisy-chain could encompass the following:
• The spread of ASF into Germany and possibly North America;
• More problems with locusts in the Middle East and Africa (spreading into Kenya and Iran);
• Additional damage to food crops from other climate change-related problems, such as droughts, flooding and wildfires;
• A possible major earthquake in Asia (like Indonesia or Japan);
• Military conflict or the threat of such action in the Middle East with the effect of driving up transport costs;
• Cyber-attacks could also complicate transportation. In 2018 a Russian cyberattack on Ukraine also tagged the Danish shipping company, Maersk, responsible for 76 ports around the world and nearly 800 seafaring vessels. The company‘s IT system was temporarily rendered inoperative. As Wired’s Andy Greenberg noted of the impact: “The same scene was playing out at 17 of Maersk’s 76 terminals, from Los Angeles to Algeciras, Spain, to Rotterdam in the Netherlands, to Mumbai. Gates were down. Cranes were frozen. Tens of thousands of trucks would be turned away from comatose terminals across the globe.” Considering the importance of shipping to the transport of food, this could also put pressure on food prices.
Currently global food stocks appear to be adequate to deal with global demand and inflation forecasts are low, though set to nudge up in 2020. The situation, however, can change quickly. The trigger of high food prices in 2010-2011 came rapidly, though the root causes had been building for years. Although food price inflation appears to be a distant issue, the root causes have been building over the last year or so. It could be a spoiler for both markets and growth prospects in 2020, making it something worth watching.
December 19, 2019
Scott B. MacDonald, Ph.D
Outlook 2020 Series, No. 1
Are Russo-European Relations Set for a Change?
Summary: Looking into 2020, one of the major developments that could come into play is a thaw in European-Russian relations. Since 2014, relations between Russia, the European Union (EU) and the West in general have been particularly bad due to the Putin government’s occupation and annexation Crimea. Although the Russian economy weathered the ensuing Western economic sanctions, the disruption of trade and investment relations hurt. Part of the Russian strategy to counter Western economic pressure has been closer ties with China. Russian energy flows to China and, in return, Chinese goods have found an important niche in Russian consumer markets and Chinese investment has headed into its neighbor. Additionally, there has been greater cooperation between the two countries in international forums. While this worked well for both countries, Russia must consider how much it wants to become dependent on China. China, after all, is aggressively creating the Belt and Road Initiative (BRI), which seeks to create a Chinese-dominated Eurasian economic zone that begins in the Pacific and ends on the Atlantic coast of Europe. Vladimir Putin, who is a shrewd geopolitical player, is keenly aware that he runs the risk of turning his country into China’s sidekick, even in those parts of Central Asia and Eastern Europe where Moscow still has influence. While a rapprochement with the U.S. is not in the cards, an option for Moscow is to improve relations with Europe. Europe is reassessing its own relations with a U.S. that is less committed to Europe and a China that that is officially viewed as a systemic rival. This will be worth watching through 2020 and could have an economic impact as well as playing out in energy markets.
One comment on Russia made during the 1990s was that it was not really a country, but an oil company with nuclear missiles. While this seemed harsh at the time, it did capture some of the dynamics at play in the Russian economy. As of 2018, energy (oil and gas) accounted for over 50 percent of exports and 30 percent of GDP. Russia is also a major exporter of other commodities such as steel, alumina, and timber as well as chemicals. All of this points to a fundamental fact about the Russian economy – it remains very much a commodity exporter. As such, it is vulnerable to global economic growth cycles and largely depends on imports to cover consumer goods, ranging from machinery and vehicles to plastic and food. Consequently, economic sanctions have a major impact. According to the International Monetary Fund (2019): “The 2014 sanctions and fall in oil prices, and subsequent additional sanctions and geopolitical tensions, raised uncertainty and dampened domestic and foreign private investment. The threat of further sanctions continues to hang over the economy”. The disruption of trade and investment with Europe was particularly painful. Indeed, the table below reflects the decline of Russian exports to the Euro Area from 2013’s $224 billion to $155 billion in 2018, a substantial drop.
The 2014 sanctions and those that followed gave greater impetus to an already-in-motion critical reassessment of Russia’s dependence on the West and reinforced the deepening of economic relations with China. Indeed, both countries are subject to U.S. sanctions. They have found their global policies at odds with the U.S. and are apprehensive of U.S. involvement in their politics. China was well-positioned in the Russian economy prior to the sanctions in 2014 and it remained the leading force in Russian imports though the period of 2014-2019. Most Euro Area and other Western countries are still below where they had been prior to sanctions.
What is likely to deepen economic ties between China and Russia over the next decade is the Power of Siberia pipeline which began operations in 2019 and connects Russian natural gas in Siberia to Northeast China. Earlier in 2019, when the pipeline began operations President Putin stated: “This step takes Russo-Chinese strategic cooperation to a qualitative new level and brings us closer to (fulfilling) the task, set together with Chinese leader Xi Jinping, of taking bilateral trade to $200 billion by 2024.”
China’s foreign direct investment in Russia has also grown since the 2014 Western sanctions. According to the American Enterprise Institute’s China Global Investment Tracker, from 2005 to 2019, China has invested $53.98 billion in Russia, with a little over $30 billion of that coming in the 2014-2019 period.
But China’s economic reach has not been limited to Russia. Chinese foreign investment has steadily been on the rise in areas that Russia regards as key to its national interests, such as Kazakhstan ($34.9 billion in the 2005-2019 period), Kyrgyzstan ($4.73 billion over the same period); and Turkmenistan ($6.8 billion over the same period). Russia was deeply concerned by what it perceived as the ongoing encroachment on Europe and the U.S. in strategically sensitive areas, such as Georgia and Ukraine. One has to wonder how it feels about China plying its economic statecraft in the same regions?
Europe has its own trepidations over a less friendly global system and the need to be aggressive in defending its economic space and moral values. As a Financial Times editorial piece noted (December 16, 2019): “The U.S. under Donald Trump, and probably his successors, no longer automatically shares Europe’s economic and security interest. China, a promising market, is now officially viewed as a systemic rival. Europe was left behind in the digital platform revolution and its risks losing out in other potentially transformative technologies, such as artificial intelligence.”
If U.S.-European relations continue to be strained over trade (protectionism exists on both sides), climate change (Europe is trying to be pro-active and the Trump administration has called it a hoax) and defense spending (mainly Europe’s weak efforts in this area), China hardly offers an alternative. That is especially the case in that China’s companies and banks benefit from close ties to the government, its domestic markets remain protected, and it is competing (often unfairly) with Europe in the Middle East, Africa and Eastern Europe for trade and investment opportunities. And then there are the political factors – China is an autocratic state and has few qualms in suppressing dissent.
That leaves Russia. While Putin’s Russia is quasi-authoritarian and not above eliminating its opponents, an opposition is tolerated (barely), state control is nowhere as pervasive as in China. Russia is not perceived as much of a systemic threat as China (unless one is in the Baltic states or Poland). Yet, the ties between Russia and Europe have deep historical roots. Moreover, for many European companies, including those from Germany, Italy and France, Russia is a natural market – it is close, familiar and has a substantial population (read consumers).
And there is the natural gas card. Europe needs Russian energy. Germany in particular is in need of Russian natural gas to fuel its economy, especially since it has closed down its nuclear industry and alternatives (like wind power) have failed to make up the difference. According to BP, Germany is the largest European consumer of natural gas, followed by the UK and Italy. For Germany and Italy, Russia is a critical supplier. Germany’s need for imported energy has been the impetus behind the $10.5 billion Nord Stream 2, an underwater natural gas pipeline set to link Russia’s gas fields to German consumers. Although the project was opposed within the EU by France and the Americans are threatening to slap sanctions on European firms building the last leg of the pipeline, the Germans have pressed ahead.
The U.S. view was best stated by President Trump: “We’re protecting Germany from Russia, and Russia is getting billions and billions of dollars in money from Germany”. Germany’s foreign minister, Heiko Maas responded to the threat of U.S. sanctions by stating that European energy policy is made in Europe, not in the U.S., while one of Chancellor Angela Merkel’s close allies in the ruling Christian Democrats stated, the potential sanctions are “no longer just an unfriendly act by the U.S. but a hostile act towards its allies.”
The expectation is that U.S. sanctions or not, Germany and Russia plan to finish the pipeline. Strategically Nord Stream 2 will help Russia replace most of the capacity that has thus far been transporting overland through Ukraine, with which it has poor relations. Russia is Germany’s leading source of natural gas, a position that is likely to be secure considering that another major import source, the Netherlands, is set to stop exporting in the not too far distant future. Although the U.S. has sought to provide Germany another option with its own natural gas, the view from Berlin is that Russia is close, the pipeline will take care of future needs, and that Russia, over the long term, is a more natural trade partner than the U.S.
Where does all of this leave Russo-European relations? Although there are obstacles to Europe and Russia returning to a more “normal” economic relationship, there is pressure from both European businesses that have lost out in the East and from EU leaders in a growing number of countries, including Italy, Hungary and Poland to reset relations. It is noteworthy that the December 2019 meeting in Paris between Putin and Ukrainian President Zelenskiy was brokered by Chancellor Merkel and French President Emmanuel Macron. There was no American participation. Finding a path out of the conflict in eastern Ukraine and some type of solution to Crimea would do much to break the logjam between Russia and Europe. Yet it will be difficult to overlook Russian interference in internal European politics, the annexation of Crimea, and Russia’s aggressive military posturing toward Europe.
At the end of his history of Russia, Dmitri Trenin, the director of the Carnegie Moscow Center, notes that U.S.-Russian relations are not likely to improve due to “Putin’s never-to-be-satisfied desire to be ‘understood’ by the United States”. Trenin brings up another potential path that harkens back to the legendary Alexander Nevsky, who defeated an army of Germans and Estonians in the famous Battle of the Ice in 1242. Nevsky also maintained a subordinate position to the Mongols, who had conquered most of what was to become Russia. As Trenin wrote, “In extremis, Alexander Nevsky’s hard choice of submitting to the East to fight off the West could be made again.”
Trenin offers one other path, which could have validity, considering the ongoing nature of projects such as Nord Stream 2. Accordingly, a more balanced approach would be: “The optimal geopolitical construct, however, would be something like a Grand Eurasian equilibrium with Berlin, Beijing and Delhi becoming Moscow’s principal foreign partners.”
Looking ahead, global political and economic systems are in flux. A new Cold War type of system is emerging, pitting the U.S. and China against each other. As the U.S. and Chinese economies decouple and the two economic powers struggle to define a new order, other relationships are being reshaped. For Europe and Russia, there is a growing incentive to reset relations. This does not have to mean a fulsome European embrace of Russia and its authoritarian politics, but finding a better working relationship. For Russia, there is going to be an increasing need to balance Chinese influence and economic clout.
It was Halford Mackinder, the British political geographer, who stated: “Who controls East Europe commands the Heartland; who rules the Heartland commands the World-Island; who rules the World-Island commands the world.” For Russia and Europe this should be self-evident, but it appears that China is the one seeking to gain control of the Heartland. This means that Europe and Russia are going to be pressed harder on just how important it is to have control over their own destinies. As the German foreign policy minister was concerned that European energy policy was made in Europe, he should also be concerned that European economic policy should be made in Brussels, not in Beijing. The same can be said for Putin’s Russia. This situation leaves the door open to rapprochement, despite obstacles. And it could happen sooner rather than later.
November 12, 2019
Scott B. MacDonald, Ph.D.
If everyone is moving forward together, then success takes care of itself.
— Henry Ford
Markets, Risks and the U.S. Economy: Still Moving Along
Summary: There has been considerable concern as to where the U.S. economy is heading. In August and September market pundits were pointing to recession, pushed along by a deepening trade war with China, a pending trade war with Europe and tough times in agriculture and manufacturing. In October sentiment shifted, with investors taking U.S. markets upwards, hitting new records in early November. European and Asian markets have also got an uplift. Although risks abound, the ability of the U.S. and Chinese governments to reach a trade deal has given the market hope and, if consummated, could help pull the global economy towards firmer terrain. The past few months may go down as a “recession scare”, but the real thing remains further out on the horizon.
The Stars Align for Markets: October was a month when the stars aligned and U.S. equity markets tiptoed into record territory. This was due to the U.S. and China making progress on the first stage of a trade deal; the Federal Reserve cutting 25 bps; and the UK finally setting a date for parliamentary elections (December 12th) as well as a new Brexit extension to January 31st, 2020. A better-then-expected post of U.S. Q3, 2019 real GDP at 1.9 percent also helped sentiment, allowing markets to ride through another negative report in the ISM Manufacturing Index for October. Geopolitical risk still percolates in the Middle East, Hong Kong and parts of Latin America (as in Chile), but we think it is not enough to derail positive sentiment.
What to make of October’s market performances? First and foremost, investors really wanted to take markets up. The combination of mixed economic data (Europe and Emerging Markets were generally negative) and geopolitical turbulence created a degree of volatility. For example, in August the VIX Index briefly headed over 20, but in early November it fell to a little above 12 (a 52-week low). The market chat is now more about a “recession scare” than a real recession, which has allowed investors to put money to work. The situation is also being helped by an earnings season which may not be robust yet is hardly a disaster. The tone of many corporate heads is constructively positive: Yes, the tariff wars are hurting, but we are still hopeful of a deal.
What comes next? The narrative going forward will be dominated by the performance of the U.S. economy, in particular, the resilience of the U.S. consumer. What comes out of China-U.S. trade talks will be more important than Brexit and the UK election. The impeachment process is likely to become more significant as the Democratic Party goes through the process of selecting its presidential candidate. The overarching drivers in all of this are the ongoing decoupling of the world’s two largest economies (China and the U.S.) and a related shift from globalization to economic nationalism. Both remain disruptive to local and international political and economic systems. But for the moment the stars have aligned, leaving the door open to more risk-on buying.
A few quick thoughts on the U.S. economy. The U.S. economy still stands out as the best place to invest and is the fastest growing of the G7 economies.Q3’s 1.9 percent real GDP growth rate for the U.S. economy, and an upward revision for Q2, points to an economy that has slipped into a slower, yet still forward-moving expansion. Sure, we are late in the economic cycle. But it’s the U.S. economy which has a consumer that still refuses to quit and has room to grow. As we have stated before, we see the U.S. economy expanding at over 2.0 percent in 2019 and for the expansion to continue into 2020. The big question is what keeps the economy going next year?
The sugar rush of the Trump tax break is over. Now, much of U.S. growth will depend on the consumer, corporate performance (spending could become an issue) and trade. Recession chances are higher for 2020 if the trade truce between China and the U.S. fails to make any real headway. A return to trade tensions would most likely speed up a chance for a downturn in the U.S., something the Trump administration is no doubt carefully weighing.
The U.S. leader also needs to bring some type of trade relief for agriculture and manufacturing, two sectors that employ many of his supporters (especially during an election). At the same time, President Trump’s counterpart, President Xi Jinping is feeling pressure on the economic front. A little more economic growth would help offset problems with Hong Kong and a rise in pork prices, a key staple in China. If nothing else, an extended truce in the trade war is something attractive to both Beijing and Washington.
This brings us to the issue of U.S. manufacturing. While other parts of the U.S. economy have demonstrated moderate paces of expansion, manufacturing has tumbled into recessionary territory. The shift from expansion to decline set off concerns over a broader recession earlier in the year. There are a couple of things to consider. Although October’s ISM manufacturing index was still in negative territory, it was better than the month prior. Moreover, manufacturing employment is actually up by 49,000 in the past 12 months, despite the temporary losses from the auto workers strike against General Motors.
Another factor to consider on the plus side for the economy is that the Fed has made three cuts in interest rates. Although it is on a pause, the Powell Fed has indicated that it stands ready to act if necessary. We expect that the Fed will probably not raise rates in December but will wait and see as to how economic data shapes up in Q1 2020. The Fed will also probably be more favorably inclined to act earlier in the year than later, considering that the country votes in November 2020. One other item to watch on the central bank front is how the New York Fed handles the repo market, which must contend with the tsunami of U.S. Treasury bonds generated by a free-spending Washington.
We are not arguing that the U.S. economy does not have problems (the widening fiscal deficit and rising government debt immediately come to mind) or that growth will continue for many more years to come. Rather we do not see a recession lurking around the corner of the next six months. The current economic expansion is the longest the country has enjoyed since records have been kept since the late 19th century and there are factors working that are likely to continue that momentum. Our bet is that there is enough to keep the economy moving, but variables like trade and debt management could play the spoiler if not properly handled by economic policymakers. If impeachment became a more serious consideration, it could add an element of political uncertainty that could erode confidence. It would be even worse if simultaneously the trade war reverted to a more rapid and bruising decoupling of the U.S. and Chinese economies and disruption of global supply chains. Otherwise, the U.S. economy will continue set new records for the length of a recovery.
October 16, 2019
Scott B. MacDonald, Ph.D.
Canada’s Election – No Impact on Strong Ratings
Summary: Canada’s triple-A sovereign ratings are stable, reflecting prudent economic management, a broad consensus on economic policies, and a high degree of political stability. The upcoming October 21, 2019 parliamentary elections are likely to be a close contest between the two leading parties, the incumbent Liberals and opposition Conservatives. Whoever wins is likely to maintain the same broad policy mix, which reinforces our stable outlook.
Politics: On October 21 Canadians go to the polls to elect a new government. The incumbent Liberals, led by Prime Minister Justin Trudeau, are in close competition in opinion polls with the Conservatives, headed by Andrew Scheer. One of the most recent polls gives the Liberals a slight lead with 34.2 percent to the Conservatives with 33.7 percent. The rest of the field is broken down to the left-of-center New Democratic Party (NDP) at 14.1 percent, the Greens at 9.7 percent, the Bloc Québécois (BQ) at 5.1 percent and other smaller parties making up the remainder.
Based on opinion polls, the Liberals are likely to win by a small margin due to their leads in Ontario, Quebec and Atlantic Canada, while the Conservatives are strong in western Canada. The Liberals are also benefiting from lost traction of the NDP on the left. Although Prime Minister Trudeau has not managed a great campaign, his counterpart Scheer is not as well-known and is seen as more conservative than most Canadians in his opposition to abortion and single-sex marriage. Moreover, Scheer’s position was hurt by the recent revelation that he has dual citizenship (his mother is Canadian and his father is American).
As for Trudeau, he has benefited from being the son of Pierre Trudeau, regarded by many in progressive circles as a philosopher-sage king in the form of one of Canada’s greatest prime ministers.1 However, young Trudeau’s climb to political power came very quickly and left him open to mistakes. These include his effort to spare the Quebec construction firm, SNC-Lavalin, from prosecution for bribery (which resulted in two high-ranking Liberal women parting company from his government), his earlier-in-life predilection to wearing blackface at a number of parties, and the Indian-costume fiasco.2
Trudeau had the good luck of being elected in 2015, before Trump in 2016, which allowed him, according to The Washington Post’s J.J. McCullough (October 3, 2019), “…to be reimagined from naïve political neophyte to youthful embodiment of stereotypical Canadian progressiveness”. Considering that President Trump is perceived by many Canadians as a bully and far to the right, Trudeau’s willingness to stand up to his counterpart has been seen as a positive. Equally important, it was under Trudeau that the Liberals left the political wilderness of having been relegated to the third party in parliament to becoming the government in just a couple of years.3 That remains an important achievement.
But Canada sits at a new crossroads, contending with how it wants to deal with the Trump administration south of the border, bringing back more fiscal discipline to the country, and reactivating stronger economic growth (real GDP is expected to grow at a lackluster 1.5 percent this year). The Trudeau administration has defined its political agenda in terms of native rights, the elevation of feminism and other gender issues, and the environment (including the melting Arctic) — all important. The challenge facing Trudeau, which gives Scheer and the Conservatives a chance, is that many Canadians would like to see lower unemployment (5.7 percent in August) and better jobs, fundamentally pocketbook issues that impact their day-to-day lives.
We see three potential outcomes for the election: a Liberal majority government; a Liberal minority government; and a minority Conservative government. We think that Trudeau’s Liberals will win re-election, but by a narrow margin.
The Economy: The Canadian economy is market-driven, high-income and closely tied to the U.S. economy in trade and investment. While Canada has a broadly diversified economy, with world-class services and manufacturing companies, the oil and natural gas sector plays a major role. Canada now ranks third in the world in proved oil reserves behind Venezuela and Saudi Arabia and the world’s seventh-largest oil producer.
Trade plays an important role in the Canadian economy. Canada’s major trade partner is the U.S., which accounts for around 76 percent of exports and around 52 percent of imports. China accounts for 4.3 percent of Canadian exports and 12.6 percent of imports (Mexico is third at 6.3 percent).
Trade relations have occupied an important role in the Trudeau government as the U.S. opted to replace the North American Free Trade Agreement (NAFTA) with a new deal, which eventually emerged as the U.S.-Mexico-Canada Agreement (USMCA). The new trade deal, often referred to as NAFTA 2.0, basically upgraded the old deal to include changes for automakers, stricter labor and environmental standards, intellectual protections, and digital trade provisions.
The major items under the USMCA were country of origin rules (automobiles must have 75 percent of their components manufactured in Mexico, Canada or the U.S. to qualify for zero tariffs (up from 62.5 percent under NAFTA); U.S. farmers get more access to the Canadian dairy market; and 40 to 45 percent of automobile parts must be made by workers who earn at least $16 an hour by 2023. The new deal extends the terms of copyright to 70 years beyond the life of the author (up from 50). It also extends the period that a pharmaceutical drug can be protected from generic competition, and includes new provisions to deal with the digital economy. When the leaders of Canada, Mexico and the U.S. signed the new deal, it cleared the way for the U.S. to end steel and aluminum tariffs on Canada and Mexico.
Impact on Ratings: We regard Canada’s ratings as stable. Although economic growth has cooled, Canada should continue to expand at a modest pace through what is left of 2019 and into 2020. Considering the close economic relationship with the United States, what happens south of the Canadian border is important. Our view is that the U.S. economy is set to slow in 2020, but not go into recession. That keeps prospects for Canada in a relatively positive light.
Canada’s debt management has been prudent. Unlike many advanced economies (like the U.S., U.K., France, Japan and Italy), Canada has actually taken its gross public sector debt from 91.8 percent in 2016 to 89.7 percent in 2018. The IMF expects public sector debt to decline further to 84.9 percent by 2020.
Canada is rated AAA by Fitch, Moody’s and S&P, with a stable outlook. Our view over the medium term is that the October elections will not disrupt the broad consensus on major economic policies.
Concluding Thoughts: Canada’s gradings are stable and likely to remain that way no matter who wins the upcoming election. Canada is one of the top three trade partners of the United States, a major source of investment in the U.S., and one of its oldest allies. It is also a country that largely leans to globalization, democracy and politeness in political dialogue. Whoever wins the October election faces a more challenging landscape – cooling global economic growth, greater trade protectionist pressures, an aggressive Russian push into the Arctic, lower oil prices, and possibly further trade tensions with the neighbor to the south.
1Pierre Trudeau served as Canada’s prime minister from 1968 to 1984, with a brief period as Leader of the Opposition from 1979 to 1980 (during Conservative Joe Clark’s brief minority government).
2In 2018 Prime Minister Trudeau and his family traveled to India for an official visit. During the visit the Prime Minister and his family donned traditional Indian attire, which was described as “too Indian, even for an Indian”. Considering that Canada’s first family posed for a number of photo ops, it soon was seen as a distraction to the Prime Minister’s trip.
3The last Liberal government in Canada before Justin Trudeau was that of Paul Martin, who left office in 2006. From 2006 to 2015 Canada’s parliament was dominated by the Conservatives under Prime Minister Stephen Harper, who won election in 2006 and reelection in 2008, finally exiting government in 2015.
August 30, 2019
Scott B. MacDonald, Ph.D.
The UK: An Umbrella Might be Useful
Summary: On August 28, 2019 British Prime Minister Boris Johnson made a major gambit on his country’s future by seeking and getting the approval of the Queen to suspend Parliament for five weeks. The pound promptly sank and most European markets sold off. Johnson needs to ride through next week’s brief parliamentary session without a vote of no confidence, which would put the country in motion for new national elections, possibly before the Brexit deadline of October 31st. That would take some doing. If an election occurs the outcome is highly uncertain, though there is the possibility that if the campaign is mainly over to exit or remain, Johnson might be able to win by a very narrow margin. There is a certain weariness among most British over the Brexit issue and many might just welcome the opportunity to get it over and done with – whatever the consequences. None of this bodes well for the UK’s sovereign ratings, due to the increased likelihood of a recession, higher borrowing to deal with probable economic dislocation and infrastructure and social spending. This scenario includes the Johnson government falling to a no confidence vote and a Labour government coming to office (which could be economically even worse). Ratings prospects would improve if some type of deal is made with the European Union or a new referendum is held (and even if the leave vote wins).
Politics over economics: To put it mildly, the UK’s political outlook is complicated and filled with uncertainty. Boris Johnson’s government holds a one-seat majority in Parliament, the nation is highly polarized over Brexit, and the economy is heading in the wrong direction.
In late August, Johnson made the situation even more complicated when he asked the Queen permission to suspend or prorogue parliament for five weeks. This was done in an effort to stop members of parliament (MPs) from launching legislation to block a no-deal Brexit. Johnson was given approval to suspend Parliament until October 14th, but it will be briefly in action in early September, providing a short window of opportunity for a no confidence vote. If successful, the UK would have to hold a new national election, probably before the Brexit departure date scheduled for October 31st.
The suspension of Parliament could also lead to a constitutional crisis. No doubt Johnson is aware of that scenario, but what happens if Parliament refuses to be suspended? Moreover, members of Johnson’s own party have called his action anti-democratic and maintain their position in favor of remaining in the EU. Johnson has to hope that enough members of the Labour Party from the Midlands and North, who voted heavily in favor of Brexit, back him. No doubt he also counting on members of the Brexit Party, a one issue party led by Nigel Farage, to back him, which could add to his ranks.
If the UK heads into a new election the outcome is not clear. The Labour Party under Jeremy Corbyn wants to renationalize certain sectors of the economy (in particular, railways and energy companies), impose heavier taxation on the wealthy, and possibly pull the UK out of NATO and end the country’s independent nuclear weapons program. Under this scenario we would also expect a sharp rise in government debt as well as capital flight.
While the Conservative v. Labour rivalry constituted the old politics, the new politics are more likely to be along the lines of pro-Brexit and anti-Brexit. Opinion polls indicate that a small majority favor leaving the EU, but that could change. The Liberal Democrats, who are clearly pro-remain, could benefit the most, though it is difficult to see them gaining enough votes to finish ahead of either Labour or the Conservatives. As we said in the beginning, Johnson could win just enough votes to win a tiny majority and go ahead with a no-deal Brexit.
One last thought on the political outlook is that if Prime Minister Johnson is successful in carrying the day with a no-deal Brexit, the existence of the United Kingdom over the long term is questionable. Scotland is pro-EU and could well call a new referendum, which could see those in favor of nationhood win. That leaves Northern Ireland adrift, possibly looking to uniting with the Republic of Ireland as the best option (despite some deep-seated opposition among Protestant-oriented parties). That would leave what is referred to as Little England, together with Wales, basically a city-state built up around London making its way in the world as an international financial and trade center along the lines of the Venetian Republic.
The economic backdrop to the election is not good. Q2 real GDP was negative, a shock to many. Manufacturing continues to head downward, London has lost jobs to other parts of Europe and British business has become cautious, meaning less hiring and spending. Rain Newton-Smith of the Confederation of British Industry recently stated, “The UK economy is being stifled by uncertainty about the UK’s relationship with the EU. The need for the new prime minister to secure a deal with the EU is urgent.”
Prime Minister Johnson’s intentions are to push through a no-deal Brexit and to borrow to finance an aggressive spending program for upgrading the health care system and national infrastructure. The UK’s gross government debt now stands at over 100.0% of GDP. (By Maastricht criteria the UK’s debt is expected to be a little over 85% in 2019.) Under a no-deal Brexit we would expect to see that debt climb, while government revenues decline in the midst of a major recession. We should add that even if the Johnson government falls, a Labour government would also be likely to increase spending and borrowing, equally negative for ratings.
Our outlook is negative. The UK’s Aa2/AA ratings are upheld by one of the largest economies on the globe, prudent finances, low unemployment and the importance of London as an international financial center. Pressure on the ratings comes from the increasing potential of a no-deal Brexit from the European Union, which is likely to put the economy in a recession (Q2 2019 real GDP was slightly negative).
August 8, 2019
Scott B. MacDonald, Ph.D.
UK- Sovereign Event Risk Alert — No-Deal Brexit October 31
Summary: Summary: There is a strong chance that Prime Minister Boris Johnson of the UK is going to lead the charge into a no-deal Brexit. Not since the British Light Brigade was sent into a frontal assault against a well-entrenched Russian artillery battery has an incident received such an historical importance, perhaps. The UK can obviously survive as an economy outside of the European Union (EU), but the UK faces a period of deep uncertainty. While we believe that the UK will be exiting the EU on October 31st, not even that event is 100 percent certain. Consequently, we see the UK’s sovereign ratings under increasing pressure over the next 12 months with a strong possibility of a downgrade.
A Challenging Landscape for the New Government
The Johnson administration was hit hard in its first week in office. This is a reflection of the UK’s challenging political and economic landscape. Last week’s bumpy ride came in the form of a plunging Pound, a Bank of England warning about a potential recession, and claims that a No-Deal Brexit strategy on October 31st could result in the UK’s breakup. The tabloids speculation included Northern Ireland opting to join the Republic of Ireland, hence remaining in the European Union, and Scotland holding a new referendum on independence, (and subsequently applying to join the EU as a separate country). That would leave England and Wales as a rump state of the UK.
Another blow hitting the Johnson government was a defeat in the Brecon by-election. Voters went to the polls in Brecon and Radnorshire to fill an empty seat previously held by the Conservative Chris Davies, who was unseated by a petition following his conviction for a false expenses claim. This time the Liberal Democratic candidate, Jane Dodds, defeated Davies (who ran again).
The significance of the election is that it has reduced Boris Johnson’s working majority in the House of Commons to one seat. As the BBC noted of the precariousness of Johnson’s government, “Now, with the thinnest majority, he will have to rely heavily on the support of his own MPs and his confidence-and-supply partners the DUP (Democratic Union Party) to get any legislation passed in key votes.”
The last week of July was not all bad news for Prime Minister Johnson: opinion polls demonstrated what is being called the “Boris bounce” for the Conservatives. One poll indicated that Johnson’s entry into 10 Downing Street opened up a 10-point lead over Labour, while siphoning off potential voters from Nigel Farage’s Brexit party. The Labour candidate finished in fourth place finish in the Recon-Radnorshire by-election. (At least he beat the Official Monster Raving Loony Party candidate, Lady Lily the Pink!).
What to take from the rash of developments? First and foremost, Johnson is clear that if the EU does not want to make concessions, he will move ahead with a no deal. At the same time, he is keenly aware that the very unity of the country is at stake, hence his recent visits to Scotland, Wales and Northern Ireland.
PM Johnson is also positioning for a rough ride ahead that is likely to include a national election. He has promised he will not hold an election before the official Brexit day of October 31, allowing him time to enact his election strategy. Once the UK pushes past October 31 with a Brexit, we are looking for the UK to increase borrowing to fund priorities such as new hospitals, full-fiber broadband and social care reform. The new PM’s strategy will keep the Conservative faithful, (including those who wished to remain), while picking up Labour voters in the north who heavily favored Brexit.
Johnson faces three risks to his strategy.
First and foremost, after the Brecon by-election his majority in parliament is wafer-thin. His government could fall at any time if a major vote is taken and lost or if a bloc of Conservative MPs leaves the party or fails to follow party lines in a vote (and there is considerable party rancor within the Conservative ranks).
Second, British politics is undergoing a realignment based more on the lines of pro- and anti-Brexit. Significantly, this could play into the hands of the Liberal Democrats, who are the only clear-cut support of a “remain” policy. The Brecon by-election is noteworthy in that Plaid Cymru (the Welsh nationalist party) and Greens decided to align with the Liberal Democrats, potentially an election alliance in the making.
The main opposition Labour Party remains uninspiring. Its candidate in the Brecon by-election was a pathetic fourth place, the leadership under Jeremy Corbyn has marched far to the left, and the party is torn over the Brexit issue. Indeed, Corbyn’s approach to the UK’s departure from the EU has been generally ambiguous, no doubt a partial reaction to the fact that many its supporters in England’s north favor leaving. At the same time, the party suffers from an anti-Semitic streak, something which many feel the party leadership has failed to address.
The next UK national elections are likely to pit a pro-Brexit (and no-deal) Conservative Party headed by Boris Johnson against a Corbyn-led Labour Party which has pledged to keep “remain” on the table. While Corbyn is sensitive to voters who want to leave, he is against no deal Brexit and insists on negotiating a Labour Brexit that includes having a national referendum on any deal that is struck. If an election is run on Brexit or no Brexit, it may be easier for the Conservatives to win the largest bloc of seats, but it could also see a pickup in seats for the Liberal Democrats (and a possible alignment with the Greens and the Welsh nationalists). Ultimately another election could strengthen the hands of smaller parties and only prolong the uncertainty.
Third, the British economy is wobbly. The Bank of England (BOE) recently downgraded its 2019 real GDP outlook from 1.5% to 1.3%. The BOE also cut its 2020 growth forecasts from 1.6% to 1.3% and warned of a possibile recession.
UK manufacturing output has fallen to its lowest since July 2012. According to Robb Dobson, a director at IHS Markit, “July saw the UK manufacturing sector suffocating under the choke-hold of slower global economic growth, political uncertainty and the unwinding of earlier Brexit stockpiling activity. Production volumes fell at the fastest pace in seven years as clients delayed, cancelled or rerouted orders away from the UK.”
A no-deal Brexit would be a double hit for British manufacturing as they are slammed by a slump in global trade (caused by the trade wars in play) and the disruption of leaving the EU. The views of Mark Carney, the head of Bank of England, are worth noting, “The level of uncertainty that is affecting businesses has continued to increase and it is clear that there has been a substantial shortfall in investment as a consequence of that.”
The Bank of England is not the only party concerned. The Confederation of British Industry (CBI) has warned that neither the UK nor the EU is ready for a no-deal Brexit on October 31, 2019. Indeed, the CBI stated, “Although businesses have already spent billions on contingency planning for no deal, they remain hampered by unclear advice, timeliness, cost and complexity.” Along these lines, the UK would have to trade with the EU on World Trade Organization terms, making its exports and imports more expensive. The UK would become more uncompetitive with the EU and others, including China and the U.S. (even if it were able to rapidly transact a trade deal with the Trump administration). The fact remains that the EU is still the UK’s largest trading partner, accounting for 46.6% of its exports; the U.S. accounts for 13.3% of UK exports and China (5.7%).
Another point of concern is the rising level of UK government debt. Although it has appeared to have peaked in terms of 2019 projections, the Johnson government appears ready to embrace higher borrowing to address a probable slump in economic growth as well as rising social needs. Any type of Brexit is going to be difficult and disruptive, but a no deal Brexit could see a lengthy period of adjustment and no or very low growth, hence a greater reliance on public borrowing. Although this is not likely to put the UK on the track of Italian or Greek debt ratios (still in excess of 100% of GDP), it points to a potential vulnerability, especially if the political picture is complicated by a new Scottish referendum and some type of move to unify Ireland (currently a distant possibility).
The UK’s ratings are under pressure. Smith’s has a negative outlook for the UK’s Sovereign Risk Grading, which it is reaffirming due to the new government’s tax and spending proposals, the potential for an erosion of the debt/GDP ratio, growing chances for a recession, and political uncertainty in terms of new elections and Scottish restlessness. The combination of these factors puts economic policymaking under acute pressure and has already eroded business confidence. Moreover, these trends are likely to get worse before they improve.
Although we see a greater potential for a no deal Brexit occurring, a new deal with the EU, including some type of agreement with the EU over the Irish backstop, could reduce some of the uncertainty and provide greater clarity to the separation process. Less disruption could translate into a quicker return to “normal” business conditions as the rules of the game become clearer.
Moody’s, S&P and Fitch currently rate the UK at Aa2 (stable)/AA (negative)/AA (negative watch). On August 1, 2019, Moody’s commented that “the new government’s tax and spending promises could further weaken the UK’s credit profile”. Fitch has the UK on a negative watch and S&P has a negative outlook.
The UK is one of the world’s major economies and has been a bedrock of the West. London is one of the main international financial hubs. However, the UK faces considerable risk in the short to medium terms, with a no-deal Brexit leading the way. We would underscore the UK can stand outside of the EU as a viable economic unit, but it is going to be a messy process. There is still time between early August and October 31, 2019 to strike some type of deal; no one is optimistic given Prime Minister Theresa May’s many failures to reach a deal acceptable to both Brussels and the UK parliament.
Considering the severe nature of the challenges ahead, we have reaffirmed our negative outlook on the UK’s gradings.
August 6, 2019
Scott B. MacDonald, Ph.D.
Is Hong Kong Another Tiananmen in the Making?
Summary: The week began with the Special Administrative Region (SAR) of Hong Kong heading into its first general strike in 50 years. With nine weeks of demonstrations, some of them violent, the protest movement has morphed from the opposition to a proposed extradition treaty between Hong Kong and China to demands for democratic reforms and an independent inquiry into police brutality. While there is a stalemate between the protest movement and the Hong Kong government, Beijing remains the ultimate arbiter of what happens in the SAR, including the use of the People’s Liberation Army (PLA). This is not to argue that President Xi Jinping wishes to use military force. Such an action would have major international consequences possibly along the lines of Tiananmen Square in 1989, which hurt the Chinese economy. However, President Xi is increasingly caught between a pro-democracy movement in Hong Kong and pressure from hardliners in Beijing to crush what they perceive as an existential threat to China’s Communist Party rule. In addition, U.S.-Chinese relations are at a low over trade and currency issues, a situation that could lead to saber-rattling. Hong Kong could be a stealth “Lehman moment” creeping up on global markets, providing a spark for other geopolitical tensions.
A complicated geopolitical landscape: What complicates the Hong Kong situation for Beijing is that the protest movement has tapped into a deep pool of resentment over Beijing’s political heavy-handedness that has been growing in recent years. In 1997 China assumed control of Hong Kong and agreed that it would accept the “one country, two systems” formula —Chinese authoritarianism would not be imposed on the SAR. For many people living in Hong Kong, China has gradually chipped away at their liberties. The extradition treaty would have further allowed Beijing to reach into Hong Kong and seek out those it perceives as a risk to its authoritarian system.
While pro-democracy activists and students began the current round of demonstrations, the movement appears to have drawn in the professional classes, which could greatly complicate matters. This was underscored late last week when hundreds of employees from Hong Kong’s banking and finance sectors gathered for a brief “flash mob”. There are indications that some of the Special Administrative Region’s civil service are supportive of the movement as well.
For its part, the Hong Kong government is warning the protest movement that they are disrupting the economy. Cathy Pacific has cut a number of flights traveling in and out of the airport and businesses have closed their doors in those areas where the authorities and protestors are active. A spokesman for the SAR stated: “Any large-scale strikes and acts of violence will affect the livelihood and economics of Hong Kong citizens. This will only undermine further the local economy that is facing downside risks, as well as the confidence of the international community and overseas investors in Hong Kong’s society and economy.” According to the World Bank, the Hong Kong economy expanded by 3.0% in 2018, but the current unrest could reduce prospects for 2019.
Already dealing with an increasingly more difficult trade war with the United States, tensions in the South China Sea and slipping economic growth, President Xi no doubt finds Hong Kong a major headache. Beijing is solidly opposed to democracy blooming anywhere under its jurisdiction. Moreover, a messy outcome in Hong Kong is likely to reinforce Taiwanese sentiment that any rejoining with mainland China will come with a curbing of political freedoms. Taiwan has developed a democratic political system, with its citizens having become accustomed to voting for their representatives and president.
The timing is ironic, given the recent death on July 22, 2019 of former Chinese Premier Li Peng, who used his authority to declare martial law and ordered the June 1989 military crackdown against the student pro-democracy movement in Tiananmen Square. For that brutal and bloody action, Li Peng has often been referred to as the “Butcher of Beijing.” China was broadly criticized and the U.S. Congress voted to impose economic sanctions against China, citing human rights violations. China’s economic growth went from double digit real GDP growth figures to 4.2% in 1989 and 3.9% in 1990 before recovering in 1991.
President Xi is between the rock of authoritarian China and the hard place of Hong Kong pro-democracy protesters. There is no easy solution. Very recently Major General Chen Daoxiang, a senior Chinese officer in Hong Kong, let it be known that the PLA would put down the protest movement in the SAR if President Xi gives the order. He stressed that “violent protests are absolutely impermissible.”
A PLA intervention would have international consequences, which could include economic sanctions with the U.S. and Europe. China might well respond by applying pressure in other theaters – a show of force in the South China Sea or a more flagrant demonstration of China’s willingness to buy Iranian oil in defiance of sanctions imposed by the U.S. to strangle Tehran’s economy.
Why Hong Kong Matters
A PLA intervention would damage Hong Kong’s reputation as place to conduct business. At risk is the economic and financial halfway house that Hong Kong provides between China and the rest of the world with a GDP estimated to be worth $363 billion. According to Terence Chong, the executive director of the Lau Chor Tak Institute of Global Economics and Finance at the Chinese University of Hong Kong, “If China wants to mix with the outside world, it needs Hong Kong to do that because capital cannot move freely outside of China. You still don’t have an alternative.”
Hong Kong is also an integral part of global finance. Most of the world’s major banks and investment funds are active in Hong Kong financial markets. Indeed, Hong Kong remains highly important to China’s corporate world. As the Financial Times’ Don Weinland, Joseph Leahy and Henry Sender noted (August 2, 2019), “In order to raise funding in US dollars, Chinese companies lean heavily on Hong Kong’s financial markets – markets which are rooted in the city’s independent legal system based on English Common Law.”
Hong Kong is also an important trade center, exporting $569 billion worth of products around the planet in 2018, representing roughly 3.2% of overall global exports. China consumes 55% of Hong Kong’s exports, much of their consumption being re-exports from a wide range of countries, including the United States, India, Japan, Germany and Southeast Asia.
Rounding out the picture, Hong Kong is also the 9th largest holder of U.S. Treasury Securities at $204 billion as of May 2019; China is the largest at over $1 trillion. Would a major incident over Hong Kong trigger a more fulsome disentangling of the U.S.-Chinese economic relationship, including a sell-off of U.S. bonds? Currently we think this is a distant possibility.
Sino-American relations are strained and at a low point. That said, both sides have not entirely given up on reaching a better place. A brutal crushing of the protest movement by the PLA, however, could spark a greater crisis and function as a potential Lehman moment for global financial markets. A Lehman moment could play out if Hong Kong is entirely shut down, with troops in the streets and blood spilled, disrupting the flow of business and creating a panic, including capital flight. It would ripple into China where the corporate sector is highly leveraged and needs access to financial markets.
China’s corporate sector is struggling under an ocean of red ink and defaults are hitting record numbers. Even before the turmoil in Hong Kong, the horizon for China’s companies was darkening. According to S&P Global Ratings Senior Director of Corporate Ratings Cindy Huang, Chinese corporations will face a liquidity squeeze in the second half of 2019. She also noted that the funding environment worsened at the end of May after the government takeover of Baoshang Bank, a private lender in Inner Mongolia. The bank takeover, according to Haung, created “volatility in the funding market and the interbank market, which has spilled over to corporate sector funding.”
China’s banks have sought to provide lifelines to the corporations, but the banks also need access to capital, some of which comes from Hong Kong’s markets. The main risk is that a shock to Hong Kong’s financial markets spreads to China, hurting the balance sheets of the country’s major banks and further roiling corporate lending.
Much depends on how President Xi handles Hong Kong. While there is a preference to let the movement burn itself out, the Chinese leader cannot be seen as backing down — such a development would open him up to potential challengers at home. Giving the green light to a PLA intervention would have heavy costs. Looking ahead, China will most likely wait for a strategic moment to impose force and regain control, perhaps using riot police and not the PLA. There can only be one emperor under heaven.
1The U.S. has let it be known that it is tracking the movement of tankers linked to China’s largest state-run oil company, CNPC, which it believes is using the Bank of Kunlun (which the oil company owns) to facilitate the flow of Iranian oil to the East Asian country. According the Financial Times, satellite data and imagery suggest that the tankers linked to Bank of Kunlun are turning off tracking devices and changing their names.
August 1, 2019
Scott B. MacDonald, Ph.D.
The Fed in an Era of Competitive Central Banking
Summary: On July 31st the Federal Reserve met and decided to cut interest rates by 25 bps, to a 2.0%-2.25% range. So far, so good. That was generally expected. What was not expected was the language and tone that followed during Chairman Jerome Powell’s news conference. In particular, the Fed head sought to reassure his audience that the U.S. central bank had not ruled out further cuts if “uncertainties” about the economic outlook remain, but he then cautioned that the cut was only a “mid-term policy adjustment.” To put it mildly, Powell left a major question mark as to whether the central bank will follow up with an aggressive rate-reducing regime. In an era of competitive global central banking (which resembles a race to the bottom by central banks lowering their rates) Fed efforts to be prudent (i.e. moving in a slow and deliberate way), leaves the U.S. at a disadvantage of being too slow in cutting rates, making the dollar less competitive in what is becoming a more sharper-elbowed global trade system, and generates uncertainty over the future of economic expansion.
What to take from the FOMC decision?
1. Stocks fell as much as 1.8% when Powell spoke, rallied a little, but still ended the day down 1.1%. This was the largest drop in two months.
2. The 10-year yield fell to 2.01%, while the two-year moved up to 1.88%. Inverted yield curve anyone?
3. The US dollar rose, gold fell and oil ended the day down at $57.92.
4. Expectations were that Powell would cut by 25 bps and provide guidance that strongly suggested another cut in the months ahead, especially considering the absence of inflationary pressures and the weakness of other economies around the globe (which has curtailed the buying of U.S. goods along with trade wars).
5. The Fed is not the only central bank to have lowered rates – while the U.S. central bank was meeting, Brazil’s central bank slashed interest rates to a record low in response to the worsening outlook for Latin America’s largest economy. The bank cut its main rate to 6.0% from the previous 6.5%, which had been unchanged since March 2018. Other central banks in the rate cutting mode recently have included Russia, South Korea and South Africa.
6. The Powell news conference also guarantees ongoing Fed-White House tensions. President Trump tweeted, “What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world. As usual, Powell let us down.” No doubt there is more on the way from the President.
Looking ahead, we expect that the Fed will seek to “clarify” the Chairman’s comments in an effort to make them seem more dovish. The next chance for a rate hike is at the September 17th-18th FOMC. Although expectations have been high for an October cut, further signs of cooling in the U.S. economy could push the September meeting to make cuts. The Fed is a conservative institution and has a track record of moving slowly; in some ways it remains focused on the last war –containing inflation. Perhaps it is time to focus on the issue of deflation, which seems to hang over the economic landscape, much like the ghost of Banquo sitting at the banquet in Shakespeare’s Macbeth, a forerunner of more problems to come.
Global Economic Doctor Spyglass: The Party Continues
July 22, 2019
Dr. Scott B. MacDonald
Summary: It is likely to be a hot summer due to geopolitical tensions, but the world’s central banks are adding more alcohol into the liquidity punch bowl by lowering rates. This means that the stock market party is not about to end – at least not in 2019. Moreover, real GDP growth for the U.S. economy in Q1 was 3.1% and is likely to be above 2.0% for Q2. We expect the year’s GDP growth to be around 2.0%, helped along by a more accommodative Fed policy and a still resilient consumer. There are, however, clouds on the horizon: Persian Gulf tensions are on the rise (especially with Iran’s seizure of a British tanker); the haze of uncertainty still hugs the Brexit coast and growth in the European Union continues to cool. And, China is feeling the pain of the tariff war with the U.S. The major overarching macroeconomic development is the tearing asunder of global supply chains that have guided the international economy for decades. What to make of all of this? We expect greater central bank accommodation to translate into further gains in bond and equity markets, though volatility will remain a constant due to the persistence and wider range of risk factors. We also expect to see some deterioration in key sovereign issuer creditworthiness due to trade and growth factors.
What keeps us up at night:
1. Trade Wars: The most significant risk to the global economy and markets is the ongoing trade wars. The U.S.-Chinese trade war has had a major dampening effect on global trade and growth, especially when considering that Europe and several Emerging Market countries have been caught in the crossfire. As the world’s two largest economies have resorted to tit-for-tat tariffs, some major sectors of global economic expansion have been hard hit: technology, materials and energy. Global semiconductor sales have fallen, shipping is struggling, world manufacturing is down (see table below) and most major international companies are restructuring their global supply chains. The key word is “uncertainty”, something which seems likely to grow in the face of a rising trade tensions between the U.S. and Europe and most recently between Japan and South Korea.
We do not see any meaningful breakthroughs in the Sino-American trade war. While President Trump relishes a good transactional tussle, China is not likely to cave to pressure due to its history of having been humiliated by European imperialism in the 19th and early 20th centuries. In the meantime, it appears that the Trump administration is interested in expanding the trade wars to Europe, which will further weaken prospects for growth, both in Europe and globally. This is bad news for the sovereign creditworthiness of Brazil, China, and Germany and good news for Vietnam, Thailand and possibly a number of African countries which have the necessary human capital and infrastructure to handle manufacturing.
2. Smith’s SLOC Event Risk Alert (-1) Strait of Hormuz: The Strait of Hormuz remains one of the most pressing hotspots in terms of geopolitical risk because around 20% of all oil traded worldwide passes through the Strategic Line of Communication (SLOC). As the economic sanctions from the Trump administration bite into the country’s exports, Tehran has responded more aggressively. Although the official response from the Rouhani government has been one of denial for most incidents in the Persian Gulf, it is questionable as to how much control the Iranian president has over the Revolutionary Guards, which have in the past demonstrated a high level of autonomy. In recent months, the U.S. has sent thousands of additional troops, an aircraft carrier, B-52 bombers and advanced fighter jets to the region as tensions have increased. While we think that leadership in Tehran and Washington prefers to avoid a military conflict, the risk is mistakes could quickly escalate to a larger crisis. A major flare-up in the Persian Gulf could rapidly become a crisis with global implications. This situation is highly negative to Iran’s creditworthiness.
3. Fed Roulette: President Trump is a frequent critic of the Federal Reserve and its chairman Jerome Powell. The U.S. leader’s efforts to browbeat the central bank leader have been consistent and motivated by Trump’s political need to have a U.S. economy in growth mode as voters go to the polls in November 2020. While it is important that there should be a discussion on Fed policy, Presidential arm-twisting could badly backfire on the current incumbent in the White House. Part of the reason for the use of the U.S. greenback as the major international currency is the confidence foreign investors have in the apolitical nature of the U.S. central bank. Take away that confidence, and the trust in the dollar and the U.S. monetary system fades and eventually runs the risk of being replaced by something different in which U.S. debt would face pressure in terms its value to other currencies. The U.S. government might actually have problems in terms of selling its debt, which could be a problem considering the ongoing rise in public sector debt through the Obama and Trump years. And then there is issue of actual Fed policy – will cuts in interest rates be enough to stave off a recession in 2020? We expect the Fed is likely to cut in late July and once again later in the year.
4. Hong Kong, Taiwan and China: As the demonstrations in Hong Kong indicate, the people in China’s Special Administrative Region (SAR) do not wish to go quietly into Beijing’s one-party Leninist political regime. Hong Kong is a problem for China’s President Xi Jinping as this clearly represents resistance to his autocratic rule. It also dampens any sentiment in Taiwan to become part of China again, especially as the island-state has an elective legislative body and presidential elections. The tighter economic conditions become in China (partially due to the trade war with the U.S.), the more President Xi’s administration is likely to crush any challenges to its authority. We expect that there are some very intense discussions going on in Beijing as to whether or not to crush Hong Kong’s dissidence and what the consequences could be. China and the U.S. are already in a new Cold War; would a hard-nosed military intervention in Hong Kong only worsen the situation?
5. The Syrian Tinderbox: Although the Islamic State has been crushed, the real test for Syria’s future is now in motion. Far removed from any market considerations, what occurs in Syria matters. The Assad regime has survived, but now Iran, Russia and Turkey are fighting to determine the shape of the future in this geopolitically pivotal state. The eastern part of the country is held by the Kurds, backed (at least for now) by the U.S. with a small military force. Complicating matters, relations between the U.S. and Turkey are deteriorating on a number of fronts. This leaves Syria a cockpit of great power politics. Probably the most serious game is between Iran and Russia. Iran wants to build up Hezbollah in Lebanon and possibly use Syria as a launching point for a war against Israel. Russia has solid relations with Israel and has little interest in an-Iran led war against Israel. Russia could benefit from Syria’s reconstruction and enjoys the benefits of air and naval bases in Syria. A war between Israel on one side and Iran, Syria and Hezbollah on the other undermines the benefits of economic statecraft. Syria remains far from global markets, but a major Middle Eastern war would bring it right onto global trading floors, impacting everything from oil prices to stunting regional trade.
6. Cyberattacks: The deeper the world moves into the digital age, the deeper it moves into a landscape of enhanced vulnerability. Almost anything can be hacked. According to a report by Sophos, The Impossible Puzzle of Cybersecurity, most IT managers feel overwhelmed by cyberattack attempts. In a survey of 3,100 IT managers across 12 countries (at organizations with 100 to 5,000 employees), two out of three of them said their organizations (68 percent) suffered a cyberattack in 2018, despite efforts to prevent them. This, despite the fact that a full 26 percent of IT’s time, on average, is spent on cybersecurity issues. Nine out of 10 (91 percent) of respondents said they were running up-to-date cybersecurity protections at the time of a successful attack, according to Sophos. The survey also showed that attacks are coming via multiple channels, including email (33 percent) and web (30 percent), software vulnerabilities (23 percent), unauthorized USB sticks or other external devices (14 percent), and more. However, worryingly, a fifth (20 percent) of IT managers said they didn’t know how their networks were compromised.
7. North Korea – Still Out There: North Korea remains one of the major unresolved geopolitical risks. It is also a major risk factor for the sovereign creditworthiness of South Korea and Japan, two countries within reach of the North’s weapons. The most recent Trump-Kim meeting in early July was a surprise but was a positive factor in keeping some type of dialogue open. Despite that, North Korea is under considerable pressure on a number of fronts: economic sanctions clearly hurt the regime; trade with China has fallen, and the weather is hurting food production. According to the International Federation of Red Cross and Red Crescent Societies, rates of malnutrition and disease are increasing due to a smaller-than-expected harvest. Erratic weather with drought and floods and a lack of resources could lead to a food crisis in the country. South Korea’s intelligence agency has also stated that the North’s economic situation is bad: facing widening trade deficits, foreign currency shortages and a deepening cash crunch due to sanctions. Considering the Kim dynasty’s past responses to difficult economic times, we would venture that North Korea will be tempted to return to a more aggressive stance to obtain food assistance, though it will remain highly reluctant to surrender its nuclear weapons program. Watch this space.
8. Venezuela – Ripples in a Bad Pond: Venezuela remains the epicenter of the new Cold War in the Caribbean. The Maduro regime has demonstrated an unexpected resilience to international sanctions due to a combination of support from its allies (Cuba, China, Russia and Turkey) and an international criminal enterprise that has allowed the president and his allies to live off the profits of gold and drug smuggling. The Maduro regime has also made a tactical alliance with the Colombian revolutionary group, the National Liberation Army (ELN). The ELN is allowed to operate out of Venezuelan territory and, according to recent allegations, is running an illicit gold mining operation in the area close to the Guyanese border. In the meantime, the refugee count out of Venezuela continues to mount. According to the United Nations more than 4 million people have left what was South America’s wealthiest country and that number could potentially reach 8 million. The UN noted that people are fleeing political chaos, food shortages, a breakdown in law and order and hyperinflation, making the Venezuelan refugee crisis the “largest in the recent history of Latin America and the Caribbean.” This crisis is increasingly weighing heavily on neighboring countries, including Brazil, Colombia, Guyana, Trinidad and Tobago, Suriname and the Dutch islands of Aruba and Curacao. The situation could eventually devolve into armed conflict, which could worsen matters further –both within Venezuela and surrounding countries.
9. Turkey – The Ongoing Economic Slide: Turkey’s economy is struggling (inflation was 17.5% at year-end 2018 and unemployment at 11.4%), investor confidence has waned with President Erdogan’s dismissal of the country’s central banker, and there is a strong likelihood of U.S. economic sanctions following Turkey’s acceptance of Russian military hardware. The IMF forecasts a contraction of 2.5% in 2019 and an anemic recovery in 2020. Sanctions could complicate that recovery. Moreover, Turkey is incurring heavy military costs due to its operations in Syria and, more recently, in Libya. Turkey’s economic situation is fragile, and policy has become driven more by political considerations than common sense. Watch for a further deterioration in economic fundamentals and Turkey sovereign ratings will remain under pressure through the medium term. We also expect greater pressure from within NATO for Turkey to depart, considering the ongoing coziness with Russia, which potentially compromises the sharing of intelligence. A major economic crisis in Turkey would not be a positive development for the region, considering the country’s heavy trade and financial linkages with the EU.
10. Mexico’s Faltering Economy: There is a growing risk that Mexico’s economy is beginning to sputter. The combination of a more problematic trade relationship with the United States, greater uncertainty over economic policy under populist President Andrés Manuel López Obrador (AMLO), and difficulties with the oil industry have slowed economic growth. Matters have not been made any better by the unexpected and acrimonious departure in July of the well-respected Finance Minister Carlos Urzúa, who was regarded as the strongest voice for moderation in an increasingly investor-unfriendly regime. In a brutal farewell letter, he accused AMLO of making policy without evidence and imposing unqualified officials in roles where they had a conflict of interest. AMLO’s response was to shrug off the departure, indicating that it was part of a total regime change away from neoliberal economics to a more egalitarian system. AMLO believes in a “Fourth Transformation”, the next phase in Mexico’s revolutionary experience, which will undo those policies that transformed Mexico from being a closed, nationalist economy toward an open, free-market economy closely integrated with its neighbors in NAFTA. Mexico needs more reforms to attract investment and increase competition to raise productivity, not a complete reversal of the economic model. The state-owned oil company, Pemex, is of particular concern as it is heavily indebted and needs foreign investment, something that AMLO generally rejects. Mexico’s sovereign ratings are under pressure and are likely to see downgrades as the drama over economy policy works its way out. (Moody’s A3 negative outlook)/S&P BBB+ negative/Fitch BBB stable but downgraded on June 5, 2019).
Levantine Ports, China and Geopolitics
July 8, 2019
Dr. Scott B. MacDonald Go to Full Report
“Investing in ports with partners is a very common model for us.” — Soren Skou, CEO of A.P. Moller-Maersk (one of the world’s largest shipping companies)
Summary: For a region already characterized by complicated politics, the scramble for ports is a new and noteworthy twist. The new game is driven by trade and investment. in the Eastern Mediterranean ports ranging from Latakia in the north to Haifa in the south. The key players are China, Iran and Russia, who need to create new opportunities as U.S. sanctions and tariffs have hurt their economies.
For China, the region’s ports are attractive as part of an extended Eurasian transportation network, aka China’s Belt and Road Initiative (BRI). At the same time, the politico-military element remains significant. A Chinese company won the bid in 2015 to manage Haifa, Israel’s largest port, home to Israel’s submarine fleet and port-of-call for the U.S. Sixth Fleet. Further complicating the situation, U.S.-Israeli relations could head into a crisis if this matter becomes part of a larger U.S.-China cold war. The contest for influence and port concessions is going to increase, especially if more headway is made on the development of large offshore blocks of natural gas (See map on page 8).
Change is coming (really)
The civil war in Syria, which started in 2011, is finally winding down.
Syria is now giving thought to a post-conflict order, in particular the need for reconstruction. According to the World Bank, the rebuilding of Syria carries a price tag of $220 billion. The major question going forward is who pays? While Iran and Russia were useful in providing military support, both of those countries have economies that are under varying degrees of stress from economic sanctions. Iran and Russia need new markets for exports and projects to employ their workers. In this regard, Syria beckons. It also means that the former allies, who kept al-Assad in power, are now competing for influence in the post-conflict Syria, while a third player, China, is increasingly engaged.
An important part of the rivalry over Syria is being played out in who gains control over the country’s ports, Latakia and Tartus. Both sit in what is regarded as a pro-government part of the country and were lucky enough to avoid the high levels of violence and destruction that visited other parts of the country. However, both ports are in need of upgrades and capital.
Latakia is Syria’s main container port and handles trade in metals, chemicals, machinery, and foodstuffs. The civil war hurt the port’s activities, but the surrounding region remains a strong agricultural exporter. Although the port is owned by the state through the Latakia Port General Company, it is managed by a joint venture between Souria Holdings (owned by a Syrian investment company) and the French shipping company, CMA CGA.
In early 2019, Iran negotiated to lease one of Latakia’s container facilities. Access to a port on the Eastern Mediterranean is an important geostrategic gain for Iran. Tehran has worked hard to develop an Iran-led Shia bloc throughout the Middle East. The U.S. intervention that earlier toppled Saddam Hussein’s regime removed a major barrier to the spread of Iran’s influence. In the years that followed, Iran developed proxies and allies in Iraq, Lebanon, Syria and Yemen with the aim of conducting a longstanding war against its major enemies, the United States, Israel and Saudi Arabia. The Syrian conflict, in particular, gave Iran the opportunity to create an arc of influence between the Persian Gulf and the Mediterranean, which helped consolidate a supply chain to Hezbollah, the most powerful political force in Lebanon.
Iran has invested a lot into its neighbor, Syria. Iranian troops were actively engaged in fighting and dying for the al-Assad government, as well as providing a steady supply of weapons. According to the Asia Times, Iran also provided the Syrian government a line of credit of $6.6 billion since 2011. In addition, Iran topped that line of credit off with another $1 billion in 2017.
More recently, Iran and Syria agreed to build a power station in Latakia which seeks to alleviate the smaller country’s fuel shortages. Beyond the commercial dimensions the port of Latakia provides the Iranian Navy with a base in the Eastern Mediterranean and a listening post for Iranian intelligence operations. Considering the tense relations between Iran and the United States, Latakia could loom larger in U.S. strategic considerations for the region. It should also make resupplying Hezbollah easier for Tehran.
Iran’s growing clout in Syria is a point of concern for Russia. Moscow is opposed to seeing Syria get pulled deeper into a relationship that could put Moscow in the middle of a war between Israel and Iran. Like Tehran, Moscow has invested heavily to keep its ally afloat. Moreover, Russia has a long-established concession at Tartus, the second largest port in the country Syria. Tartus is Russia’s only overseas naval base, allowing the Russian Navy to refuel and repair without having to head back through the Turkish chokepoints to the Black Sea. Russia also has a large military air base outside of Latakia, from which it launched raids on anti-Assad forces. Syria recently agreed to sign a new 49-year lease for the Russian Navy. The Russians in turn agreed to help upgrade the port, which could help it regain its commercial importance.
The growing rivalry over Levantine ports is not limited to Latakia and Tartus. It also extends to Tripoli and Beirut in Lebanon and Haifa in Israel. China is the new mover and shaker, carefully taking into consideration changes that are coming in the aftermath of the Syrian conflict and its needs under the BRI. Tripoli looms large.
Dealing with the New Geopolitical Paradigm
June 20, 2019
Dr. Scott B. MacDonald
“The great questions of the day will not be settled by means of speeches and majority decisions but by iron and blood.” — Otto von Bismarck
Summary: Spin the geopolitical wheel and it seems wherever the needle lands something is going on – the Straits of Hormuz, the South China Sea, and the U.S.-Mexican border. The whiff of tear gas hangs over Caracas, Hong Kong and Port-au-Prince. One wonders what happened to globalization and multilateralism. The simple answer is that they are slipping away and the forces of nationalism and protectionism are replacing them. Indeed, the world has entered a “new Cold War” and geopolitical risk is likely to increase in the years ahead. Trade will not disappear, but will become less important while global growth is likely to track on a more moderate pace. For investors, strategies are being constructed around what securities fit into their geopolitical bloc and how risk outside the bloc can be managed. This raises questions over companies with extended supply chains and Emerging Markets. Economic sectors less dependent on external variables will probably be more attractive, but profitability expectations will have to be brought more in line to a world with greater risk and slower growth. But we would add that slower growth does not necessarily mean recession — indeed the Fed’s pivot could result in lower rates longer, helping the growth cycle move into 2020. All the same, volatility will be a steady companion as the new Cold War deepens.
Big Changes, Big Consequences
The core change in the global economy is the rise of China, which is probably the most significant development since the end of the Cold War. It represents a challenge to the “old order” defined by U.S./Western dominance in global trade, financial markets and ability to influence other countries. Since 1978 China has undergone a massive transformation from being predominantly rural and agriculturally-oriented to being an increasingly urbanized country, which has assumed the mantle of being the workshop of the world.009 and 2016 period alone, fighting between the rebel and government forces has resulted in the death of 30,000 people.
Napoleon Bonaparte once stated, “China is a sleeping giant. Let her sleep, for when she wakes she will move the world.” Although Napoleon is long gone, China in the early 21st century has woken and is moving the world. This includes a sustained effort to recreate China’s rightful place in the world as the Middle Kingdom, the center of all things. The Chinese way is built around an autocratic leader, backed by a single political party, grounded in nationalism and heavily geared to state capitalism.
Although China still has tremendous challenges at home, it is doing what the U.S. did in the aftermath of the Second World War, creating an institutional framework for Middle Kingdom 2.0. This includes the Belt and Road Initiative (BRI) (with the goal of tying together Eurasia’s various economies from the Pacific to the Atlantic), the Asian Infrastructure Investment Bank and the Silk Road Fund. These give Beijing the ability to project power and dominate Eurasia and, through that landmass, the world.
The U.S. finds itself in the role of the British Empire in seeking to contain or accommodate the rise of a rival power. In the nineteenth century, Germany was a latecomer to unification and colonial empire, both of which upset a longstanding balance of power in Europe and led to tensions in the world’s far corners. The German challenge was constructed on the sinews of economic and military power, which eventually led to an arms race and ultimately war. In the lead-up to 1914, it was thought impossible for there to be war between Germany and Britain. Indeed, Sir Norman Angell’s The Great Illusion (1910) put forth the idea that the economic cost of war was so great that no one could hope to gain by starting a conflict the results of which would be so destructive. The results were horrible, but the conflict nonetheless happened.
The U.S. remains a formidable economic and military power, but the real competition with China is just beginning. Looking ahead, the rivalry will focus more on who gains the commanding heights of technology (like AI and telecommunications). But the rivalry will also focus on other factors, such as China’s efforts to replace the U.S. dollar with the yuan, access to international capital markets, access to China’s rare earths (see table above), consumer market access and quite possibly, the creation of competing Internets of Things. This also means that prospects for a trade deal between the two powers are not high. Any deal done is likely to function like a truce as it is very difficult to resolve the issues dividing the two powers.
China is also active in creating a broad range of partners, many of which are authoritarian in their political makeup and regard U.S. power as a threat. Chief among these is Russia, which has interfered in U.S. politics and backed governments that have clear-cut differences with Washington, such as Venezuela, the Assad regime in Syria and, at times, Iran. Under Vladimir Putin there has been an aggressive push-back against the West’s push deeper into Eastern Europe (Georgia and Ukraine), a region seen of paramount geostrategic importance to Russia.
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U.S. Jobs Numbers — A Signal of More to Come?
June 11, 2019
Scott B. MacDonald, Ph.D.
Summary: Last week’s report on the May U.S. jobs numbers was disappointing, with general consensus that the results were "weak." According to the Bureau of Labor Statistics, non-farm payrolls increased by 75,000 in May, missing the Wall Street estimate by 100,000. Private Industry payrolls increased 90,000 m/m, but Public payrolls fell 15,000. Additionally, March payrolls were revised lower by 36,000 and April payrolls were revised lower by 39,000. The bottom line is that much of the stock market regarded the jobs numbers as bad. The Fed may now move sooner in lowering interest rates, possibly as early as the June 19-20 FOMC meeting (though July would be more likely). Markets responded favorably to prospects of the Fed taking action, with the dollar heading down and the ten-year Treasury heading toward 2.084%. The upcoming week is likely to be dominated by a further back-and forth between Beijing and Washington on trade. The positive sentiment over the Fed cutting rates will weigh more heavily with markets than other factors. But, the outflow of U.S. economic data will be closely watched, including inflation, weekly jobless claims, and industrial production (on Friday).
We would take the following points from the May numbers:
1. While the numbers were not good, neither were they a disaster. Despite Wall Street’s gloominess over the direction of the U.S. economy (based on the jobs numbers and tariffs), one month does not make a trend. The U.S. economy still remains ahead in terms of job creation. Least it be forgotten, the unemployment rate remains at a 50-year low at just a little over 3.6%.
2. Average Hourly Earnings of all employees rose for the 19th consecutive month, up 0.06% M/M to a record high of $27.83 in May. On a Y/Y basis, average earnings rose 3.11%, which is a marginal decrease from 3.23% prior. Additionally, Average Weekly Hours were unchanged at 34.4 hours. Lastly, Average Weekly Pay increased 0.22% M/M and 2.81% Y/Y to a record $957.35.
3. Job growth slowed in most industries in May, but not enough to signal a looming recession – at least at this stage. Workers were most hurt in those sectors impacted by tariffs, including transport warehouse, retail and information services. If the trade wars intensify, that dynamic could worsen.
Our view: While the jobs number was not good, more data is required to assert if this a trend. We will be watching these and other employment-related numbers closely to see whether the economy is heading into either a soft landing (after a record 10-year growth streak) or hard landing. We would weigh another increase in Chinese tariffs and the imposition of new tariffs on Mexico as negative to the economy, upping the chances for a hard landing. With this in mind, the June FOMC will probably see either a 25 bps cut or language that sets up a cut in the following meetings (dependent on data). We concur with Constance Hunter, KPMG’s chief economist who appeared on Bloomberg last Friday morning, in her assertion it is questionable whether one rate cut would suffice to stave off a slowdown, especially if the tariffs all come into effect. The other factor that points to a slowdown is that the impact of the Trump tax cuts are gradually diminishing and run out late in 2019.
This takes us to U.S. industrial production (see above), which is slowing. Q1 was slow and Q2 could be slower, especially as the drag factor of tariffs came into play. Most of the major manufacturing companies are exposed to some type of international trade interaction. Consequently, investors will be closely watching the June 14 industrial production number for May.
While there are concerns over the U.S. economy, it is important to underscore that the U.S. remains the strongest growing economy within the G7 advanced countries. As of June, the U.S. set a new record for the longest expansion since the late 19th century. While challenges clearly lie ahead, the U.S. banking system has been overhauled, bad loans cleaned up and balance sheets strengthened.
A healthy bank system is much more conducive to economic growth than one hobbled by a legacy of bad debts and low profits. The U.S. expansion was also helped by fiscal stimulus, and during the Trump years, deregulation and a tax cut. Nothing lasts forever, including economic expansions, but the next leg of the journey will be to engineer a soft landing. That is what markets will increasingly be focused on.
The failure to fully clean up the banks is an issue for Europe, where Germany’s largest bank, Deutsche Bank, is struggling with low profitability and doubts over its business model. Indeed, in early June the German bank was downgraded by Fitch from BBB+ to BBB, due to multiple management changes, restructurings that have not worked and failed merger talks with Commerzbank (the country’s other struggling bank giant). Italy’s banks carry considerable bad loans and concerns have been raised about the future profitability of French banks.
One last item to consider is cooling industrial production in Germany. Why do we care? It is the world’s fourth largest economy, a major force in global trade, and a core country for the European Union. Whither goes Germany, the rest of the EU goes. Lately the world has become a more challenging place for the German economic machine. Closely tied to the China and U.S. markets for exports, the trade war between the Americans and Chinese is hurting German manufacturing and exports. In April, the German foreign trade balance declined €2.9 billion to €17.0 billion. Exports fell 3.7% M/M to €108.7 billion, which was the worst monthly decline since August 2015. Imports also fell 1.3%.
The threat of a trade war with the U.S. over autos cast a long shadow over the German economy. Berlin is keenly aware that U.S. tariffs could hurt it. While German (read European) counter-measures would no doubt seek to exact payment in kind by the Americans, a trade war ultimately comes at a bad time for Europe’s largest economy. As Germany’s central bank, the Bundesbank, stated in the aftermath of the bad export numbers, “The German economy is currently experiencing a marked cool-down. This is mainly attributable to the downturn in industry, where lackluster exports are taking their toll.” The Bundesbank’s President Jens Weidmann added, “As things currently stand, the downside risks predominate for economic growth.”
German industrial production declined 1.9% in April from March, worse than a forecast of 0.4%. The German car sector, a major exporter, has also been hit by a fall in demand for vehicles in not just China, but also the EU.
Germany’s real GDP is now expected to expand at 0.5%-0.8% for the year, a result of downward pressure from the manufacturing sector related to the U.S.-China trade war and Brexit uncertainties. The situation is serious enough that the German government is beginning to use fiscal stimulus (something they are usually against doing) to help maintain economic momentum and hopes that domestic demand will keep Germany on the growth track. It also means that the European Central Bank, as seen by its June 2019 meeting, will be dovish through the upcoming months as concerns over a recession in Europe are increasing.
Rising Sovereign Risk…at Least for Now
May 16, 2019
Dr. Scott B. MacDonald
Summary: The world of sovereign credits has seen risk climb higher over the past couple of weeks, and one of the economic impacts is on U.S. corporations. Not the little ones — the big U.S. corporations that get a large share of their profits from overseas. Overall about 44% of S&P 500 firms’ sales come from foreign markets. Consequently, additional risk to U.S. corporate earnings will come if the China-U.S. trade war slows China enough to produce weaker growth in the Asian economy, with a knock-on effect to other overseas markets, U.S. multinationals and other U.S. trade partners (like Europe, Japan and Brazil). It’s something to watch as the Trump Team gets pushed along with new tariffs and the pushback from China.
Adding to the sovereign risk is an upping of tensions in the Persian Gulf between Iran and the U.S. Given the Iranians have control of the largest dry dock in the region, it doesn’t make a lot of sense for them to blow up a freighter in the Straits. More likely some poor unhappy person from, say, Pakistan, plants a bomb below the deck rather than an Iranian Guard.
And, of course, we are in the run-up to the May 23rd European Union parliamentary elections. The trade issue is the most weighty as it hangs heavy over the Chinese and American economies as well as the rest of the world (which includes the EU). Although we believe that a China-U.S. trade deal will be worked out in the months ahead, ongoing friction between the two countries is likely to continue. A number of economic issues pertaining to technology and copyright laws will be difficult to bridge, while geopolitical tensions will continue over such issues as the South China Sea, Taiwan, and Beijing’s penetration of Africa and the Western Hemisphere (most recently underscored by events in Venezuela). We also note the potential for sovereign ratings pressures to re-emerge in Europe if trade protectionism rises further and growth cools in key economies, like Germany, Italy and France.
China-U.S. Trade – A Few Quick Thoughts: While we concur with the Trump administration’s being tough on China to create a more equitable agreement, we do have concerns that the ongoing turn to tariffs will function as a brake on the U.S. economy. This comes in two ways.
The first is that tariffs are a tax. Higher tariffs on Chinese goods are eventually going to be transferred from importers to consumers. While this is likely to function as a brake on the U.S. economy, the impact is not likely to be noticeable in the immediate term due to the strong growth fostered by the Trump tax cuts and deregulation. First quarter U.S. economic growth was an unexpectedly strong 3.2% and unemployment is now around 3.6%, two impressive numbers by any standard. The U.S. remains a growth engine in the global economy – at least through 2019. But as tariff costs filter into the general economy, a number of sectors will find the business environment more challenging, including retail, warehousing and transportation. Moreover, Chinese counter-tariffs and trade actions will continue to hurt the agricultural sector.
As we mentioned at the beginning of the briefing, the second economic impact on the U.S. is that U.S. corporations get a large share of their profits from overseas.
The U.S. economy has demonstrated considerable strength, making it the most powerful growth factor in the global economy. This is not to say that there are not problems – the budget deficit has widened; government debt to GDP is substantial, and both Republicans and Democrats both seem to like the idea of spending more money. That stated, the Trump tax package and deregulation have boosted economic growth, while some sectors have benefited from protectionist trade policies. The challenge ahead is to manage the trade issue with an eye to economic growth. Using tariffs against China as a weapon against that country’s unfair trade practices is one thing; continuing to wage trade wars with a widening list of countries (which would be done over autos with Europe and Japan) runs the risk of boomeranging on the U.S. economy. All of this will certainly be taken into consideration by the U.S. Federal Reserve. If the tariffs become long-term and slow growth, chances of a rate cut are likely to increase. But much will depend on how the central bank sees the economic direction and how much the consumer pulls back. We see rates staying where they are now through much of the year, but trade policy will increasingly be felt as the year enters its second half.
April 6, 2020
Scott B. MacDonald, Ph.D
A New World Taking Shape in the Mist
Summary: It is difficult to escape coronavirus. Between the major cable networks running scoreboards numbering the infected and dead and the barrage of stories on social media, the virus dominates the news flow. The only other major story beyond coronavirus is the oil price war between Russia and Saudi Arabia, which is causing a considerable amount of discomfort in the U.S. and Canadian oil patches. The virus and the oil price war are a one-two punch to the global economy and are reshaping the world. As 2020 plays out, our approach to cross-border economic relations, travel, urban planning, healthcare and the structure of daily life is changing. The bottom line is that coronavirus is the black swan that most of us failed to see.
We would make the following observations about how our world is shaping up:
1. The coronavirus has accelerated the process of de-globalization. The backlash against globalization had already started before U.S. President Donald Trump was elected, but his administration clearly helped bring back the idea of the strong border and economic nationalism. For all of the U.S. leader’s chest-beating about taking a tougher stance on trade, the Trump administration never intended to bring global trade to a halt. Coronavirus has taken us several steps beyond the outcome of the trade wars. Global trade has collapsed. At the same time, much of the world depends on trade to help economic growth, but it has to be more balanced. If nothing else the shortage of basic medical supplies, like face masks and plastic gloves, has painfully emphasized that being overwhelmingly dependent on one country for most supplies is not a good idea. Managing de-globalization is going to be a difficult task.
2. The world has become much more Darwinian in a very short period of time. This hits on two levels: (1) governments are now competing over access to essential medical supplies and other critical goods and (2) there is a shift toward rationing on the part of society. An area worth watching in advanced economies is who has access to companies like Amazon, Kroger and Walgreens and the services they offer and who doesn’t. These companies have increased hiring and are functioning as quartermasters for the U.S. economy. But you must be able to afford it. If you lack a credit card or your finances are stretched, you won’t be able to purchase key goods and have them delivered to your doorstep. You will have to take your chances at the local grocery store, where you are more exposed to contracting coronavirus.
3. The age of the consumer as we know it is over. Since the 1970s the consumer has been king. For a long time, the world was constructed around consumers, pushed upwards on the economic food chains by the advance of larger and more luxurious shopping malls at the high end and big-box retail at the lower end. Globalization with Western accents expanded the consumer culture around the world with Tiffany, Chanel and Courvoisier replacing the rustic austereness of Mao and Gandhi. This system was based on a combination of just-in-time supply chains that were willing to sacrifice American and European workers, a heavy dependence on cross-border commerce and transport, and a belief in the ongoing upward social mobility of billions of people. Now, between trade wars and coronavirus, the world of retail, shopping malls and fashion fickleness is being eclipsed by the need for basic goods produced closer to home. Fashion is out and dependability is in. You can’t eat fashion, but locally grown and affordable food served up hot does a lot to keep the grim reaper from the door.
There is another important point to be made – the “new dependable” companies (some listed above) reflect the trend toward more activity taking place in digital form, a process made possible by the fusing of traditional businesses with online technologies. As the Financial Times’ John Thornhill (March 20, 2020) noted: “Why talk about fintech, healthtech, and edtech when all finance, healthcare and education companies will function on both levels?” Coronavirus has only sped up the process and the melding of traditional and digital companies has been evident in dealing with the crisis. One reflection of this is that while Amazon, Kroger and Whole Foods are hiring workers, Macy’s, Kohl’s and Gap are furloughing theirs.
4. There is a blurring of the line between public and private sector economic activities. Since the coronavirus commenced, there has been a flourishing of Public-Private Partnerships (PPPs). The White House has been active in invoking a wide range of emergency powers,such as shortening the testing time for new drugs and asking GM to make ventilators. At the same time, companies from key sectors like big pharma, retail distribution and grocery, have stepped up. The longer the medical crisis is, the longer this trend is likely to continue. It also extends to how far the U.S. government will go to bail out or bail-in (government takes partial ownership) corporate sectors. In the U.S. there remains considerable debate over whether Boeing should receive federal help. The same debate is going on over U.S. energy companies, which have been hurt badly by the plunge in oil prices to around $20 a barrel (they briefly slipped below $20 in late March). The bruising fall in oil prices has been more pronounced in landlocked oil production centerslike the U.S. Permian Basin and Alberta, Canada. A number of major U.S. oil names, such as Marathon Oil, Apache and Occidental have seen their stock prices savaged. Any bailout of U.S. companies, including airlines and energy, raises the question of moral hazard. This leaves the big question: if the government steps in, what are the conditions of a bailout or a bail-in? What does this blurring of government and private sector activity foretell for the post-coronavirus economy?
5. The coronavirus is setting up the planet for a more intense and sharp-elbowed geopolitical landscape, with the Sino-American rivalry dominating, but with other contenders seeking their place in the new power game. China is already spinning a new coronavirus narrative — the virus is a weapon allegedly deployed by the U.S. to hobble Chinese industry. Obscured in the new narrative is that the coronavirus broke out in Wuhan and that the Communist government’s suppression of initial discussion about the virus hindered a prompt response for the rest of the world. Moreover, China’s claims to entirely have halted the coronavirus are considered suspect. China is now urging the citizens of Wuhan to go back to the shopping malls, restaurants and other entertainment venues. China has begun sending help to other countries, including Italy and the Netherlands (mind you many of its face masks sent there were faulty). //www.foxnews.com/world/wuhan-residents-say-coronavirus-figures-released-by-china-dont-add-up; //time.com/5811222/wuhan-coronavirus-death-toll/.
The main zone of this intensified rivalry is going to be Eurasia, with the major prize being Europe, an affluent, yet aging consumer market controlling a key geo-economic space that backs up to Eurasia and faces outward into the Atlantic and Africa. Here is where the destinies of the U.S., China, and Russia are going to be played out. The politics engaged will include everything from energy needs to manufactured goods, tourism and investment. The Cold War suspended Europe’s geopolitical importance, but the New Cold War between the U.S. and China has brought it back. In the middle of all of this, Europe has to decide if it wants to be the battleground, much like Germany and the Holy Roman Empire were in the Thirty Years War or if it wants to make the hard decisions to make it into a global power in its own right – beyond its so-called soft power. Coronavirus is one of those once-in-a-century events to function as both as a black swan and a catalyst.
6. Domestic U.S. politics are likely to get more contentious. Coronavirus has left the U.S. political scene greatly unsettled. Before coronavirus, the U.S. political system had become highly polarized, fragmented along a number of societal cleavages ranging from urban-rural, interior state-coastal state, racial, and economic. In many respects, there is an air of Germany’s ill-fated Weimar Republic (1919-1933) in which a number of forces are seeking to revive the idea of a strong nation and traditional values, colliding headlong with other societal forces that yearn for new freedoms of expression, ranging from political experimentation (the growing attraction of socialism) to sexual identity (encompassing everything from bathroom access to which pronouns are appropriate). One of the worst things that could happen is that the 2020 elections are postponed due to virus-related problems. Considering the sharp cleavages, such a development could send people into the streets.
The Trump administration and Congress agreed to a $2 trillion stimulus package, while the Federal Reserve has been active in providing liquidity. It is likely that a second large package will be required, especially when considering the needs of the states in dealing with the crisis and the shutdown of local economic activity. The U.S. economy is heading into a deep contraction with high unemployment in the second quarter and will spend the rest of the year seeking to find the path back to growth and employment. The ranges of contraction are substantial, with the worst cases calling for a GDP decline of up to 35 percent for the April-June quarter. Social distancing and the closure of a wide range of retail outlets, malls, restaurants, and movie theaters is decidedly having an impact on an economy where the consumer accounts for 70 percent of economic activity.
It was Mark Twain who is attributed with saying, “History doesn’t repeat itself but it often rhymes.” In a sense, our unsettled world, reflects the uncertainty of earlier periods of history such as the period leading up to Britain’s Glorious Revolution in the late 17th century, the outbreak of the French Revolution in the 1780s, and the turbulent 1930s that led to the bloodbath of World War II.
The global economy has turned a corner, shifting from a world of cross-border trade and investment, marked by a fulsome embrace of world culture to a major and unexpected black swan event that has pushed the global economy down a different path. Global economic recovery will come, but it will need a return to a more balanced form of globalization. For the U.S., major challenges loom as the recovery will probably take longer than expected. Nonetheless, 2020 will go down in history as a watershed time and it is up to us to meet the new challenges.
5.1.2020 US Economic Outlook
4.14.2020 Food Supplies Under Pressure
3.18.2020 The Risk of a
Life During Coronavirus
2.18.2020 Outlook 2020 - Beyond Brexit
1.28.2020 Outlook 2020 - Coronavirus
1.21.2020 Outlook 2020 - China-US Trade: Phase One
Outlook 2020 - Food Prices
Outlook 2020 - Russo European Relations
Markets, Risks and U.S. Economy
UK Sovereign Risk Report
7.22.19 The Party Continues
6.20.19 Levantine Ports, China and Geopolitics
New Geopolitical Paradigm
U.S. Jobs Numbers
More Stormy Weather...
4.06.2020 A New World Taking Shape
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