US-China Trade War Effect on the EU

US-China Trade War Effect on the EU

Back in March we introduced and briefly discussed Trump’s intention to impose tariffs on steel and aluminum goods. In less than a year those trade disputes escalated in a trade war, impacting not only the two involved countries but also other trading partners, including the EU. The disaffection versus international institutions has been driven by their inability to include the weakest parts of the population from feeling the benefits of the globalization process. While globalization has triggered economic growth and substantial real income growth in developing countries, the middle class of developed nations has not experienced the same benefits, leading to a decrease in purchasing power and a rise in protectionist sentiment.

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The main idea behind Trump’s rhetoric was to reduce the large trade surplus China has with the United States. Trump previously described the widening deficit, which Washington has said is around $100 billion wider than Beijing reported, as “embarrassing” and “horrible”. China and the EU were among those expressing their concerns regarding steel and aluminum tariffs and have threatened the US with applying a number of countermeasures. Jean-Claude Juncker, President of the European Commission, announced that the union will engage in a collective response with other countries affected by American measures and expressed EU’s intention to draft a list of retaliation tariffs amounting to $3 billion.

Since then, Trump’s actions have shaken the very foundations of global trade, with billions of dollars worth of goods from the EU, China, Mexico and Canada. The protectionist measures imposed by the American president have escalated into a full-fledged trade war between China and the US. An economic showdown between world’s largest economies does not look great for anyone and the EU’s manufacturing and industrial sectors are largely affected. Clearly, those sectors are monumental for Germany – the world’s fourth largest industrial nation.

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Potential Paradigm Shift?

As the US is escalating the trade war, it will be more difficult for China to accommodate American demands. There are few effective ways for China to retaliate without hurting its long-term development. An alternative would be to open up to the world’s largest economy to the EU. Thus, there is an expectation of a possible collaboration between China and the EU, given that China accepts the longstanding demands of the EU on better market access and give-and-take approach. Within this scenario we would observe a paradigm shift in terms of US-China economic relations. The EU Commission currently maintains a neutral stance towards Chinese exports. So, the result would largely depend on whether EU chooses to align with the US to protect its market from the Chinese market or maintain the neutral policies. By maintaining the neutral stance, EU could substitute the US and China in each other’s markets to an extent. Given that US does not hit the EU directly and EU maintains a neutral stance, potential gains for EU industries are relevant for the motor vehicles and aircraft sectors as well as other sectors combining over $200 billion altogether.

Germany’s GDP Growth

In the third quarter of 2018, German output contacted for the first time since 2015 and this helped push the euro zone growth down to just 0.2%. This weakness is expected to continue in 2019, with the German GDP Growth rate revised down from 1.8% to 1% due to the global economic slowdown. Furthermore, the euro zone does not have the economic backdrop to increase rates, since the ECB ended its net asset purchases in December. Therefore, the benchmark rate is likely to remain the same, making it harder for the EU to offset the effects brought about by the trade war.

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The main factor contributing to this contraction is the German auto industry. German car production decreased by 7.4% quarterly and this subtracted 1% from expansion in the industrial production and 0.3% from Germany’s GDP growth. The reason for this decrease comes partially from the new environmental standards for passenger cars, as producers could not make the vehicles as quickly as they desired.

Another reason for the Germany’s GDP slump might be China’s economic slowdown as China is one of Germany’s largest trading partners. China is facing economic issues arising domestically due to financial instability and externally given the trade tensions with the US. In October, China’s financial team went into overdrive with ten meetings within two months and Vice-Premier Liu He’s team was under pressure to resolve problems caused by the trade war that slowed the country’s growth. China’s economy officially grew only 6.4% on YoY basis in the fourth quarter, its slowest rate since the global financial crisis. A lack of growth in investments and consumption is the main driver of this lackluster performance.

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Weakness In The Car Industry

Back in June, Germany’s Daimler cut its 2018 profit forecast, while BMW stated it was looking at “strategic options” because of the trade war. Thus, the companies sparked fears of earnings downgrades in the auto industry. Daimler stated that import tariffs on cars exported from the United States to China would hurt sales of its Mercedes-Benz cars, resulting in slightly lower EBIT for the year. Morgan Stanley’s analysts added that Daimler will not likely be the only Original Equipment Manufacturer (OEM) to reduce its guidance. Other OEMs are exposed to similar trends in various degrees.

Daimler’s rival BMW, which also exports from the United States to China and Europe reaffirmed the profit forecasts, adding that these would largely depend on unchanged global political conditions.

 “Within the context of the current discussion concerning additional tariffs on international trade, the company is evaluating various scenarios and possible strategic options”.

European Central Bank’s Hard Work

Mr. Draghi of the ECB and Mr. Weidmann of the Bundesbank seem to agree that the policy should be normalized without delay. This suggests that the ECB remains determined to end net asset purchases by the end of 2018. Still, German exporters are vulnerable to the slowdown in external demand and the risk of trade tensions between Europe and the United States.

So, what should the ECB focus on? The Quantitative Easing program launched in 2015 with the intention to reduce the risk of deflation has come to an end last December. The key EU Inflation Rate rose above the ECB’s target of close to but below 2% for 2018, making it harder to justify an extension of the QE program.

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The ECB held its benchmark refinancing rate at 0 percent on October 25th and said it would stop to make net purchases under the asset purchase programme at the end December 2018.

This situation has changed in the past months as the effects of the Trade War have been felt on both the real economy and financial markets globally. The sharp slump in energy prices, a contraction in Exports and finally Consumer Sentiment drifting lower from high levels have consistently reduced Inflation and GDP Growth expectations for the EU Area. As a result, it is highly improbable that Mario Draghi will be able to follow through on ECB plans towards normalization in the short term. The continued reinvestment of the proceeds from bond redemptions will be necessary to provide stimulus to the European economy for the years to come. Moreover, ECB should use the forward guidance to thrust back market expectations over the key interest rate rise – something which would weaken the euro and further loosen the financial conditions. The ECB’s next moves largely depend on the upcoming levels of inflation and economic activity, which are linked to politicians’ ability to solve trade disputes and restore confidence.

Trade War Detente

China and the US have agreed to not impose new tariffs up until March, when a definitive agreement is expected to be reached. Furthermore, China’s Ministry of Finance removed the 25% tariffs on American-made cars and 5% on specific car parts for three months. This shows the willingness of both sides to cooperate and work towards a larger trade deal, but only time will tell whether this willingness will convert into a desirable outcome. As commentators pointed out, any positive cooperation including negotiation or even talking would help settle the markets, while continuing tensions will instigate investors to withhold their money.

Even if according to the United States Trade Representative several outstanding issues remain, the possibility of an expedited trade deal has helped stabilize the markets in the last weeks.

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 The Dow Jones Industrial Average gained 163.08 points (0.7% increase) to 24,370.24 – its highest level since December 13.

The upcoming elections of 2020 in the US oblige Trump to find an agreement in order to maintain his electoral base and increase his probability of reelection. According to reports from various sources, US officials are willing to grant China sizeable concessions in further negotiation rounds to reach an agreement before the deadline. It is unknown if this is enough to restore confidence in the system and the first test is expected in few months on the other side of the Atlantic Ocean. In May there will be the elections for the European Parliament, with Eurosceptic Parties gaining ground thanks to the widespread economic malaise exacerbated by the Trade War. The March meeting proves to be essential for all the parties involved, making extremely hard to forecast future upcoming events.

Authors: Nikita Borzunov, Mario Stopponi

The website and the information contained herein is not intended to be a source of advice or credit analysis with respect to the material presented, and the information and/or documents contained in this website do not constitute investment advice.

 

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Our view on 2019

Our view on 2019

What’s up buddy?

At the beginning of 2018, the VIX, an instrument which tracks the volatility of the S&P500, surged dramatically showing a comeback of fear among investors (Figure 1) following a period of extreme calm started after the financial crisis.

Figure 1: Higher VIX since February 2018

Figure 1

Source: Bloomberg

February’s spike in volatility led to further speculations about a coming correction or bear market as the end of the bull market started in 2009. Through 2018, we saw an increasing number of headlines on the coming bear market but, on the contrary, the main US equity indices kept reaching new highs without giving any signal of a downturn. However, during the week starting on October 8, the main US equity indices fell raising concerns about the beginning of a correction. On October 10, the S&P 500 swept 4% from its all-time high with the 60% of the stocks composing the index down >10% from the 52-week high, therefore in correction’s territory. Over 130 components fell at least 20%, level at which a bear market is recognised. Why did that happen?

We believe that the main drivers of the market downturn were:

  • The tightening monetary policy in the US and expectations on the ECB’s interest rates hikes starting from mid-2019;
  • Rise in fixed income products’ yield shifting capital allocation from stocks to less-risky assets (e.g. bonds);
  • Slowing inflation around the globe giving signal of a slowdown of the global economy;
  • Emerging markets’ downturn due to political instability (e.g. Venezuela) and higher oil price (e.g. India);
  • A stronger dollar causing weaker currencies around the world, especially in emerging markets;
  • Concerns over the trade war between USA and China and other political crises fuelling uncertainty in financial markets (e.g. Italy, Venezuela, Turkey, Iran);
  • Higher oil price increasing companies’ expenditures hence lowering margins;

On top of these drivers, on October 9, the IMF lowered its guidance on 2018 global economy growth to 3.7%, down 0.2% from April estimates. We believe that the combination of these factors together with the negative sentiment fuelled by the newsflow, triggered last week investors’ sell-off which led the main US indices down, as observable in Figure 2.

Figure 2: S&P 500 (white), NASDAQ 100 (green) and Dow Jones (orange) LTM %change

Figure 2

Source : Bloomberg

So, given the current situation, what should you expect for 2019?

Main topics

We believe that 2019 will be a turning-point year for investors with the main focus being on the following topics:

  1. Monetary policy
  2. Inflation
  3. Trade war
  4. Oil price

Monetary policy

After the beginning of the latest financial crisis, central banks pumped liquidity into financial markets and lowered interest rates in order to sustain the real economy suffering from a troubled financial system. The Asset Purchase Program (APP), also known as Quantitative Easing, was first started by the Federal Reserve (FED) in November 2008 and officially ended in January 2014. However, the FED waited until the end of 2015 to hike interest rates when it brought the US FED Funds Rate from the historical low of 0.25% to 0.50%. In September 2018, Jerome Powell announced the third interest hike in 2018 bringing the US central bank’s benchmark rate to the range of 2.00-2.25% (Figure 3).

Figure 3: Increasing US Funds Rate starting from the end of 2015

Figure 3

Source : Federal Reserve

The comeback of higher interest rates was triggered by the concerns around rising inflation and a potential overheating of the American economy. However, apart from making financing more expensive, the tightening monetary policy impacted the bond market, particularly increasing the 2-year US treasury bill’s yield to 2.85% from the 1.92% at the beginning of 2018 (Figure 4).

 Figure 4: 2-year US yield curve rose 48% YTD

Figure 4

Source : Bloomberg

As a rule of thumb, when the yield of government bonds surges, more risk-adverse investors shift their money from stocks to bonds as they can earn a decent return carrying the risk-free US Treasury bill. This shift of capitals from shares to fixed-income products generated a selling pressure on the stock market contributing to the above-shown downturn of the main US equity indices (S&P500, Dow Jones, NASDAQ). Looking ahead, we see the shift in capital allocation likely to continue as bonds’ yields increase due to the execution of the planned interest rates hikes announced by the FED. We see Powell’s schedule to be respected with 1 more hike in 2018, 2 in 2019 and 1 in 2020, leading the US FED Funds Rate to a potential 3.00-3.25% interest rate by the end of 2020 vs 40-year average of 5.72%. On top of that, the European Central Bank (ECB) announced the end of its APP to come in by the end of 2018 and consensus expects a first interest rates hike coming in in the second half of 2019. Albeit the political tension coming from Italy, we are aligned with consensus and believe that the ECB is set to hike the current -0.25% reference rate starting from mid-2019. An increase in European interest rates is likely to fuel the shift effect, leading to further sell-offs in the European stock market.

Inflation

US economy seems to be on the verge of the cool-off. Annual inflation showed a slowdown to 2.3% in September 2018, down from the 2.7% in August (Figure 5) and a miss vs expectations at 2.4%. It is the lowest rate since February and likely to be attributable to a sharp slowdown in gas prices. Since 1914, inflation averaged 3.27% reaching the high of 23.70% in June 1920 and the low of -15.80% in the same period one year later.

Figure 5: US inflation rate evolution since the beginning of 2018

Figure 5

Source : US Bureau of Labor Statistics

On October 15, US Commerce Department released data on US retail sales showing almost-flat growth with motor vehicle spending being offset by the biggest drop in spending at restaurants and bars in nearly two years. Retail sales rose 0.1% mom, 0.5% below expectations but up 4.7% yoy. Consumer spending accounts for more than two thirds of US economic activity. Despite historical low unemployment rate at 3.7% in September 2018 and 3Q18 expected 3.5% annualized growth in consumer spending, we see a slowdown in US macroeconomic data in 2019 and 3Q18 US GDP growth around 3.00%, down 1.2% from 2Q18. Adding to this, we see Trump’s rhetoric against the FED supported by investors’ that are losing confidence in Jerome Powell. JP Morgan recently published a report showing that the market reacted negatively to all the speeches given by Powell since the beginning of his mandate, quantifying the effect of his words in a US$1.5tn wiping away effect. This shows that investors are concerned about the speed at which the FED is executing its hiking plan as the expectations on US inflation are slowing down (Figure 6) putting investors on a wake-up call.

Figure 6: US annual inflation rate down in 2019-23E

Figure 6

Source : Statista.com

Trade War

On July 6 of this year, the US imposed 25% tariffs on US$34bn of imported Chinese goods in the beginning of what escalated to a proper trade war between China and US. On September 24, Trump’s administration imposed 10% more tariffs on US$200bn Chinese goods and China retaliated on US$60bn of US goods.

In this scenario, investors were scared of the potential effects that the neo-protectionist policies might have on their portfolio. In order to get a sense of how the trade war impacts companies, we looked at the luxury goods industry. Chinese authorities are implementing strict controls on travellers with the objective to look after imports over the duty-free allowance of CNY 5,000  (US$730). Chinese customers represent c.40% of the revenues for brands such as Louis Vuitton (LVMH) and Gucci (KERING) and a drop in purchases from Chinese customers would have a significant negative impact on the top-line of luxury brands. No wonder why on October 10, LVMH plunged 7.14% despite the company published strong results. We believe that investors reacted to the sentence of the head of Investors Relations at LVMH, Chris Holly, stating that the company is “subject to important risks and uncertainties that could cause actual results to differ materially” from previous forecasts. The entire luxury goods industry lost ground since the beginning of October, showing a more marked drop than other industries (Figure 7).

Figure 7: MSCI luxury good index (orange) down more than MSCI Technology (white) and MSCI Emerging Market (blue) since the beginning of October.

Figure 7

Source : Bloomberg

The example of the luxury industry gives a general understanding on how the trade war is already impacting equities and gives also a taste of the potential consequences that further escalations might have on the global stock market. We see the tensions between China and US to continue through 2019 leading to more industries being negatively impacted and a downward pressure on the global equity market.

Oil price

In October 2018, Brent oil – the main benchmark for oil price – was up 50% from the same period last year, reaching US$85.16 per barrel on October 9.

Figure 8: Brent spot price rose 50% since October 2017

Figure 8

Source : YCharts

The spike in oil price was mainly driven by the sanction imposed by the US government on Iran that lowered the OPEC’s member oil production to 3.4mbd (million barrels per day), down c.400,000 bpd from August 2018. Oil price is very sensitive to changes in supply/demand shifts and such a drop in supply makes oil scarcer hence increasing its value, therefore price, in the market. Higher oil price means rising energy costs for companies which will have to deal with increasing expenditures to keep the business going. This puts companies’ margins under pressure and translates into lower expected earnings per share (EPS). Therefore, investors see their expectations on dividends per share – computed as portion of EPS – decreasing and the equities’ bottom line shrinking. We see the oil price continue to rise in 4Q18 on the widening of supply/demand gap due to the uncertainty coming from Saudi capacity to cover the Iranian production wiped away by US sanction.  Also, we think it is worth to keep an eye on the development of the latest scandal on the US-based journalist disappeared in the Saudi consulate in Turkey since potential sanctions on Saudi Arabia from western countries would put further upward pressure on the oil price.

Food for thought

The last two weeks were characterized by the sell-off, but also by the US investment banks’ 3Q earnings releases. In the 3rd quarter of 2018, US banking sector’s results were overall positive with an improvement of the Net Interest Margin (NIM) – difference between interest income and interest expenses – thanks to the rising interest rates environment in the US. However, the IB – Global Markets divisions did not show much improvement. Indeed, results from the Sales & Trading departments of the biggest US investment banks (e.g. JP Morgan, Goldman Sachs and Morgan Stanley) delivered an overall performance below expectations. Therefore, one might draw the conclusion that investors are not exchanging their stocks for other financial products at higher frequency than last year, otherwise the level of fees should have been higher. Indeed, it seems that investors are selling their holdings without replacing those with other financial products, lowering the trade volumes hence commissions for the IB trading floors. From this perspective, one might argue that investors are taking out money from the market and building their cash piles in order to prepare for the worst-case scenario. As a corroborating factor of this thesis, BlackRock, the world biggest asset manager, had inflows below expectations in the last quarter showing a lowering investors’ appetite to put money in financial markets rather than under their mattress.

We believe that financial markets are impacted by a collection of reasons which go beyond the “Main topics” illustrated in this report. We are convinced that psychological, irrational and behavioral variables drive the market on daily basis together with financial, rational and economic factors. Therefore, we urge the reader to explore as many alternative explanations as possible when looking for reasons to justify markets’ moves.

Authors: Alessandro Sicilia, Lorenzo Bracco

The website and the information contained herein is not intended to be a source of advice or credit analysis with respect to the material presented, and the information and/or documents contained in this website do not constitute investment advice.