Weekly global economic update September 2018
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Week of September 17, 2018
China: Higher inflation, slower growth
Consumer price inflation in China has accelerated to a six-month high, but mainly for reasons unrelated to the trade war with the United States. Prices were up 2.3 percent in August versus a year earlier,1 the fastest rate of inflation since February and the second fastest since December 2016. However, the acceleration has been attributed to the effect of bad weather on food prices as well as to an outbreak of swine flu, which boosted pork prices.2
It appears that trade restrictions are not yet having an impact on Chinese consumer prices. However, if the United States imposes new tariffs and China retaliates, it is likely that this will influence the path of China’s consumer price index. Still, given that China has alternative sources for many products that it imports from the United States, it seems unlikely that China will face a significant boost to inflation as a result of trade disputes. Meanwhile, core prices, which exclude the impact of volatile food and energy prices, were up 2.0 percent from a year earlier. As such, underlying inflation remains well below the central bank’s target of 3.0 percent. In addition, producer prices were up 4.1 percent in August from a year earlier, down from the 4.6 percent rise in the prior month.3 As the government undertakes efforts to stimulate growth in the face of a restrictive trade environment, low inflation could allow it to act with impunity. At the same time, if government stimulus leads to a further drop in the value of the renminbi, this could boost import prices and contribute to higher inflation.
Yet despite recent steps by China’s government to boost economic growth, the latest economic indicators for August point to a further deceleration in activity. Most notable has been the continued decline in the growth of fixed asset investment. In the first eight months of 2018, fixed asset investment was up only 5.3 percent from a year earlier, the slowest rate of growth since the series began in 1996.4 Public sector investment was up 1.1 percent, while private sector investment was up 8.7 percent. Investment by manufacturers was up a robust 7.5 percent, while investment by utilities was down 11.4 percent. The overall slowdown largely reflects a decline in investment in infrastructure. A spokesman for the government noted that, “Infrastructure investment [growth] has been falling for some time. As local governments continue to launch [new] legally compliant projects, infrastructure investment may stabilize, but based on our estimates, it will be difficult for [investment] growth to rebound.”5 Although the government has lately eased credit conditions in order to fuel more investment in fixed assets, it is not expected to make a big difference.
Meanwhile, Chinese industrial production was up 6.1 percent in August versus a year earlier, a bit better than the 6.0 percent growth in the previous month, but slower than the more than 7 percent growth seen earlier this year. Retail sales growth rebounded from 8.8 percent in July to 9.0 percent in August, but still slower than the nearly 10 percent growth seen earlier this year. Exports strengthened, however, rising 6.9 percent in August from a year earlier. Nonetheless, a Chinese government official noted that the boost in export growth might be because US importers are accelerating purchases lest they face higher prices once new tariffs are implemented. As such, it appears that, in the short term, the trade war might actually be having a positive impact on the Chinese economy. Yet this is likely to be short-lived.
The global role of the euro
One question often asked by our clients is whether the US dollar will ever relinquish its role as the dominant trading currency, perhaps to be replaced by the euro. Interestingly, European Commission President Jean Claude Juncker has recently called for the euro to become a global currency.6 He bemoaned the fact that the lion’s share of global trade, including trade conducted by European countries with the rest of the world, takes place in US dollars. He evidently believes that Europeans would be better off if more of their trade took place in euros. Moreover, European leaders have expressed concern that the United States is using its currency as an instrument of foreign policy, threatening to sanction European companies that do business with Iran in US dollars. The European Union (EU) would like to immunize such companies so that Europe can continue to abide by the nuclear agreement with Iran, even though the United States has walked away from that agreement.
Still, there are a number of obstacles to reaching the goal of an internationalized euro. First, unlike in the United States, there isn’t a deep market for euro-denominated debt. The existence of the Treasury market in the United States helps to grease the wheels of global finance in dollars. Second, although the European Central Bank (ECB) has supervisory powers over banks, it lacks the degree of authority that the US Federal Reserve enjoys. Rather, European countries regulate their own banks, creating greater risk to the currency. There is also no central fiscal authority in Europe as there is in the United States. Finally, making policy decisions in Europe can be difficult. Many decisions require unanimity among the member countries. This can hamper a quick response in a crisis situation.
Nonetheless, the euro has some positive attributes. The Eurozone has stable prices, reasonably stable governments, financial-market transparency, and a strong and vibrant economy. The euro could eventually become a global currency depending on circumstances. For now, the United States has what a past French President once called an “exorbitant privilege”7 in that it can issue debt with abandon knowing that it faces no currency risk nor risk of capital flight. This is due to the dominance of the dollar and helps to keep US borrowing costs low. Yet the United States could lose its “exorbitant privilege” if it politicizes the dollar and if the EU gets its act together and creates the conditions necessary for a global currency.
Meanwhile, there are lately some new obstacles to European unity. These include the anti-integration attitudes of governments in Italy, Hungary, and Poland, and the threat of extremist parties that have grown in strength in other countries such as Germany, Austria, Sweden, and France. However, there does not appear to be any impetus for another Brexit anywhere else in the EU.
Inflation expectations and the Federal Reserve
One of the main tasks of a central bank is to anchor expectations of inflation. Expectations are critical as they can influence actual inflation. For example, if there is an expectation that inflation will rise significantly, then businesses will be more willing to raise prices, consumers will be more amenable to paying higher prices, and workers will be more likely to seek pay increases. The end result will likely be higher inflation. The evidence suggests that, in the United States, the Federal Reserve has done a good job of anchoring expectations. We know this because we can measure expected inflation reasonably well.
The best measure is the so-called “breakeven” rate. This is calculated by subtracting the yield on Treasury Inflation Protected Securities (TIPS) from the yield on regular Treasury bonds. The principal on the TIPS bond moves in line with inflation. Thus, the yield is the after-inflation return. Therefore, the difference between the yields on the two bonds is the expected rate of inflation. Lately, the 10-year breakeven rate has been hovering around 2.1 percent, almost exactly the same as the Federal Reserve’s target of 2.0 percent inflation.8 Moreover, since April, the breakeven rate has actually declined gradually.
Thus, even as the economy has evidently accelerated and as the labor market has tightened, investors have not upwardly revised their expectation of inflation. Why not? The reason is that the Fed’s actions, along with its expected actions based on the verbal guidance provided by its leadership, have convinced investors that the Fed will likely be successful in restraining inflation. This will come about through the Fed continuing to raise short-term interest rates in order to offset the stimulus to the economy coming from the government’s tax cut and increased spending. Consequently, as the government’s fiscal policy attempts to boost activity in the face of a tight labor market and increasing bottlenecks, the Fed will likely act in the opposite direction, slowing the economy and suppressing inflation. The problem with this scenario is that, ultimately, the Fed’s actions can create sufficient stress in credit markets to cause a slowdown in credit creation and, therefore, likely set the stage for the next economic downturn.
Emerging markets respond to turmoil
In the face of declining currency values across emerging markets, two key countries—Turkey and Russia—took surprising actions last week to stem capital outflow.
- One of the reasons why Turkey has been in turmoil lately is the reluctance of the central bank, under pressure from the government, to raise interest rates in the face of high inflation, capital flight, and dramatic currency depreciation. This has undermined investor confidence and, consequently, caused further currency depreciation. Thus, it is noteworthy that the central bank last week raised the benchmark interest rates by 625 basis points, from 17.75 percent to 24.00 percent. The lira jumped more than 5 percent in response.9 Meanwhile Turkish President Erdogan reiterated his unconventional view that high inflation is due to high interest rates and that high interest rates are a “tool of exploitation.” At the same time, he said that Turkey’s central bank is truly independent, a fact that was seemingly confirmed by the decision of the central bank to sharply raise rates. Of course, if the central bank had failed to act, the result might have been a serious run on the lira. The latest action offers investors hope that Turkey’s financial situation might be stabilized.
- Meanwhile, Russia’s central bank has raised its benchmark interest rate for the first time in nearly four years. Recall that, the last time it raised rates, in 2014, Russia was facing a sharp depreciation in the ruble stemming from a steep decline in the price of oil. At that time, the central bank took dramatic steps in order to fight inflation and stabilize the currency. Once the price of oil rebounded, Russia’s situation recovered and inflation fell to a historically low level.10 Now Russia is raising the rate from 7.25 percent to 7.5 percent, a modest increase of 25 basis points.11 This follows considerable downward pressure on the ruble, which fell from roughly 58 rubles per dollar in April to about 70 rubles prior to this decision. The decline in the ruble was similar to the recent experience of many other emerging markets. The central bank said that it acted after inflation was reported to be higher than anticipated, at 3.1 percent in August. This means that the central bank is acting preemptively while inflation remains relatively low. Then again, inflation had been in the range of 2.2 to 2.5 percent for the past year,12 so the increase to 3.1 percent was relatively dramatic and likely reflected the impact of a declining currency on import prices. The bank cited “risks from external threats and the financial markets’ reaction to them” as reasons to be vigilant. This was in reference to the rise in the value of the US dollar as well as sanctions imposed by the US government that have likely caused foreign investors to be averse to Russian securities. The ruble rose strongly in response to the central bank’s surprise decision. The ruble had also increased following the Turkish central bank’s decision to raise interest rates dramatically. Investor confidence will likely remain strong given the high regard investors have for Russia’s central bank Governor Elvira Nabiullina as well as the fact that Russian President Putin has allowed her to act independently.
Ten years later, looking at the effects of the global financial crisis
Last week marked two important anniversaries. It was the 17th anniversary of the terrorist attacks on New York and Washington, and it was the 10th anniversary of the collapse of Lehman Brothers that precipitated the worst economic crisis since the Great Depression. The demise of Lehman, which was the result of the collapse of the market for mortgage backed securities, stunned investors because many had expected the US government to resolve the problem as it had done with respect to Bear Stearns. The bankruptcy led to the seizing up of credit markets, thus threatening to undermine the entire US banking system. Ultimately, the Federal Reserve took decisive steps, including taking over AIG, which had insured the securitized mortgage-related assets issued by commercial banks, and thus preventing a collapse of multiple banks. The Federal government injected equity into big banks and the Federal Reserve engaged in an unusually aggressive monetary policy meant to circumvent the banking system and prevent a collapse of the money supply—which is what had happened during the Great Depression of the 1930s. Despite these efforts, and efforts of other governments and central banks, the world descended into a deep recession with high unemployment, high risk spreads, a collapse of global trade, and a collapse of the massive US housing market. At the time of the Lehman event, there was serious discussion about a financial collapse. Although there has since been a recovery, many things have happened as a consequence of that crisis. These include the following:
- There are now far more restrictive regulations of the financial system in the United States.
- There were massive increases in the assets of major central banks, leading to historically low interest rates for a prolonged period of time, which fueled a sharp rise in asset prices.
- Income and wealth inequality increased as upper-income households benefitted from rising asset prices, while lower-income households saw stagnant wages related to an excess supply of unskilled labor.
- There was a substantial restructuring of the US economy, with a shift in growth away from housing and consumer spending as well as a shift away from real estate and construction.
- There was a massive increase in US government debt, which offset the drop in private sector debt. The rise in government debt and government interventions in the housing market fueled the Tea Party movement in the United States. High debt and low interest rates will likely limit the ability of the government and the Fed to respond to the next downturn.
- There was a massive buildup of Chinese debt as China undertook efforts to stimulate its economy in order to offset the collapse of trade. This debt now likely poses a risk to China’s growth and could limit its response to the next downturn.
- The Eurozone debt crisis in 2011–2013 probably would not have happened in the absence of the global financial crisis. That crisis exacerbated high unemployment and contributed to the increasing political fragmentation now seen in Europe.
- The crisis exposed fault lines in the market-based economy, and undermined political support for centrist ideas. This broadened the appeal of populist parties of both the left and right. In recent years, candidates of such parties have performed well in multiple countries across developed and emerging markets.
Week of September 10, 2018
Update on trade disputes and trends
The new rules on automotive trade in the proposed US-Mexico revision of the North American Free Trade Agreement will significantly boost the cost of producing cars in North America, according to a leading think tank.13 That is because the rules involve new requirements for domestic content, creating greater complexity and thereby reducing the benefits of free trade. The Mexican government estimates that 30 percent of cars made in Mexico for export to the United States do not currently meet the new domestic-content requirements.14 Thus, if the deal is implemented, manufacturers will likely have to redesign their supply chains. These new rules will not, however, apply to cars made elsewhere and sold in the United States. Thus, in the absence of a big increase in import tariffs on cars, the deal could lead to a decline in the sale of cars made in North America. This is the opposite of what was intended.
Currently, cars imported into the United States from outside North America face a 2.5 percent tariff. The US administration, however, has threatened to impose a steep 25 percent tariff on automotive imports.15 Although US membership in the World Trade Organization (WTO) sets the maximum US tariff on automotive imports at 2.5 percent, the United States is considering activating a rarely used provision of US law that enables the president to impose steep tariffs on the basis of national security considerations. This is the same law that the administration used to justify its tariffs on steel and aluminum. Both the WTO and the European Union (EU) object to this.16 In the case of steel, the United States pressured South Korea to accept “voluntary” quotas on exports in exchange for exemption from tariffs.17 The United States might attempt to do the same thing regarding automobiles imported from Europe and elsewhere. Either way, the end result will likely be higher prices for US consumers. Moreover, if the prices of automobiles sold in the United States increase significantly, US consumers will have less income available to spend on other things. That, in turn, could have an adverse impact on employment in other sectors.
As the United States prepares to impose tariffs on US$200 billion in imports from China, America’s technology companies are lobbying the US government to exempt key technology products from tariffs lest they cause a rise in prices and a loss of jobs. In a letter signed by executives of four of the largest technology companies in Silicon Valley, the technology companies urged the US government not to tax imports of networking equipment.18 Referring to the office of the US Trade Representative (USTR), the letter stated that “if [the] USTR were to impose a 10-25 per cent additional duty on networking products and accessories, it would cause broad, disproportionate economic harm to US interests, including our companies and US workers, our customers, US consumers, and broader US economic and strategic priorities.” The letter was released on the last day in which the public could offer comments on the proposed tariffs.
The networking equipment involved includes servers, routers, switches, and motherboards. These are used by some of the world’s biggest technology companies. Such companies are investing heavily in expanding networks in order to meet rising demand for online services. Tariffs will likely cause increases in the prices of such services as well as stymie the pace of investment. Whether the US government will heed the demands of the technology companies is not yet known.
Following the United States’ withdrawal from the Trans-Pacific Partnership (TPP), a free trade agreement between the United States, Japan, and 10 other Pacific Rim nations, there has been an accelerated push to complete the Regional Comprehensive Economic Partnership (RCEP), which will be a free trade agreement between 16 Asia Pacific nations. These include the 10 members of the Association of Southeast Asian Nations as well as China, Japan, India, South Korea, Australia, and New Zealand. The RCEP effort has been led by China and negotiations have gone on for six years.
China, which was excluded from the TPP, was pleased to see it go and saw the TPP’s demise as an opportunity to boost its own geopolitical footprint in the region. Moreover, now that the TPP is defunct, replaced by a much smaller agreement that excludes the United States, and now that the United States is engaged in protectionist policies, China and Japan are keen to cement closer economic ties and find new opportunities to trade freely.19 Indeed, Japanese Prime Minister Abe said, “As we are faced with concerns of the rise of protectionism in the world, all of us in Asia must unite.” When the United States was still involved in the TPP, Japan was less enthusiastic about the China-led RCEP. That status has clearly changed.20 Ministers from the RCEP countries met in Singapore recently and are said to have made progress.
There is now an expectation that the agreement can be finalized in 2019. However, India has concerns that could prove to be an obstacle to reaching an agreement.21 India is wary of allowing more imported goods from China, worried that it will harm Indian manufacturers. In addition, India wants the RCEP to include trade in services, which is considered one of India’s strengths.
Emerging market contagion
It appears that there is increasing financial contagion in emerging markets as equity prices and currency values deteriorate in many countries in the aftermath of the crises in Turkey and Argentina. Indeed, there has been an increase in statistical correlation of equity prices between emerging markets.22 Why is this happening? What are the potential implications?
The possible reasons for declining asset prices and currency values in many emerging markets include:
- The US dollar is elevated and could go higher, given the mix of fiscal and monetary policy in the United States.
- The crises in Turkey and Argentina have drawn attention to the structural risks that already exist in other countries, including high levels of external debt (such as in Indonesia) and excessive fiscal deficits (such as in Brazil).
- There is political risk in some countries, such as Brazil that will soon have an election that could result in more statist policies, and India where next year’s election could weaken the existing coalition.
- There is concern that a trade war between the United States and China could hurt trade flows in other parts of the world, and could lead to a sharper depreciation of the Chinese renminbi.
If contagion worsens, it will mean further depreciation of emerging market currencies, greater inflationary pressures in these countries, and the necessity for central banks to boost interest rates, thereby slowing economic growth. Declining currencies could also mean greater financial stress as debtors face greater difficulty in servicing their external debts. This, in turn, could mean trouble for local banks as well as for global banks that are highly exposed to these countries. Weakening economic performance in emerging markets could create social and political unrest, and could lead to the election of populist governments that engage in policies that are not market-friendly. For the developed world, trouble in emerging markets could mean a weakening of exports and problems for banks that are exposed to emerging markets.
Here are some of the latest events from emerging markets:
- The Indian rupee fell sharply to an historic low against the US dollar last week. This is a fairly good example of contagion, given that India’s economic fundamentals are reasonably good. At the same time, the recent rebound in the price of oil likely alarmed investors, given that India is a net importer of oil.23
- Chinese equities fell sharply as investors braced themselves for the likely imposition of new tariffs by the United States. This suggests the possibility of further depreciation of the renminbi if the government allows that to happen.
- Indonesia’s currency has been falling sharply, reaching the exchange rate last seen during the financial crisis 20 years ago,24 a fact that caused some alarm. However, comparisons with the past are not necessarily relevant. In 1998, the US dollar rose more than 800 percent against the Indonesian rupiah in a matter of months.25 Nothing of the sort is happening now. Moreover, Indonesia has more reserves, greater financial transparency, a smaller budget deficit, and a much smaller external deficit than was the case 20 years ago. Thus, it hardly seems at risk of a serious crisis. Still, there has been concern among investors about the falling rupiah, and there is evidence of accelerating capital flight. Many investors are said to be concerned about the sharp rise in debt owed by state-owned companies, much of it denominated in US dollars.
- The head of South Africa’s central bank dismissed any comparison between his country and Argentina or Turkey. Lesetja Kganyago said, “You have a situation in Turkey where the president pronounces on interest rates. Look at these countries and the standing of their central banks. We have a credible central bank, underpinned by the constitution.”26 He was responding to investor concerns that South Africa may face further depreciation, especially after it was announced that the country had fallen into recession. In addition, the African National Congress, the governing party, has called for the central bank’s shares to be nationalized. This is seen as a threat to the central bank’s independence. Referring to the proponents of central bank nationalization, Kganyago said, “They call themselves radical economic something something. Those ones must be stopped in their tracks, because they will bring the central bank into the realm of politics. Elsewhere macroeconomic populists felt that central banks must do all of these unorthodox things, and they ended up with completely orthodox outcomes.” In other words, when countries veer from orthodoxy, they are ultimately compelled to return to orthodoxy in order to avoid disaster. That is now happening in Argentina and will probably happen in Turkey. Venezuela, in comparison, is already facing disaster because of the failure to adopt orthodox policies.
Japanese household spending trails income
Household spending in Japan grew in July for the first time since January, but remains unresponsive to the significant gains in household income. Specifically, household cash earnings were up 1.5 percent in July versus a year earlier, while household spending was up only 0.1 percent.27 A strong job market, combined with modest wage gains, explains the improvement in income. Nonetheless, consumers are not fully responding, although spending is no longer declining as was the case in recent months. The current trend is likely a source of frustration for the government, which would like to see economic growth shift away from a reliance on exports and toward domestic demand. As for exports, there is growing concern about the protectionist trade policy of the United States. Although the United States has aimed its wrath primarily at China, Canada, and the EU, there is said to be concern within the Japanese government that the United States might decide to take aim at Japan.28 In addition, Japan exports considerably to China, especially to provide inputs that are used to assemble products for export to the United States. Thus, Japan is likely vulnerable to the trade war between the United States and China.
Strong US job growth and accelerating wages
The latest employment reports from the US government indicate that the job market remains exceptionally strong. In fact, the tightness of the market has finally been sufficient to generate a substantial increase in wages. The government publishes two reports: one based on a survey of establishments, the other based on a survey of households. Let us consider both.
- The establishment survey found that 201,000 new jobs were added in August, far more than were needed to absorb new entrants into the labor force.29 This was roughly in line with the growth seen in the past year and demonstrates that, despite a tight labor market, the economy continues to grow strongly with rising demand for workers. By industry, there was strong growth in construction, but a decline in employment in manufacturing. The latter was due entirely to a sharp drop in automotive employment. Within services, there was strong growth in professional and business services, healthcare, leisure and hospitality, transportation, and wholesale trade. There was a decline in employment in retailing and in the information sector. Average hourly earnings were up 0.4 percent from the previous month and up 2.9 percent from a year earlier. The latter figure was the highest since 2009. However, it remains roughly consistent with the rate of inflation. As such, while wage growth is accelerating, it is not generating significant real increases in consumer purchasing power. The question, then, is whether the strong job growth and acceleration in wage growth are sufficient to cause the Federal Reserve to switch gears.
- The separate survey of households revealed that the unemployment rate remained unchanged at 3.9 percent.30 However, it also indicated that the number of participants in the labor force declined in August and that, consequently, the participation rate fell. Participation remains low compared to past experience, in part due to a decline in female participation.
Eurozone growth, fueled by exports and investment, decelerates
The EU released its final estimate of second-quarter gross domestic product (GDP) growth. Both the Eurozone economy and the economy of the larger 28-member EU grew 0.4 percent from the first quarter and grew 2.1 percent from a year earlier.31 Annual growth in the Eurozone has been decelerating for the past several quarters, having peaked at 2.8 percent in the third quarter of 2017. The slowdown in attributable to higher energy prices, weaker global demand, and uncertainty about trading relations. By country, annual growth in real GDP was 1.9 percent in Germany, 1.7 percent in France, 1.2 percent in Italy, 2.7 percent in Spain, 2.7 percent in the Netherlands, 1.4 percent in Belgium, 3.0 percent in Austria, 2.3 percent in Portugal, 1.8 percent in Greece, and 2.5 percent in Finland. Outside of the Eurozone, growth was 1.3 percent in the United Kingdom, 3.3 percent in Sweden, and 0.6 percent in Denmark. In Central Europe, growth was 5.0 percent in Poland, 2.4 percent in Czech Republic, 4.6 percent in Hungary, 4.2 percent in Romania, 3.4 percent in Bulgaria, and 3.9 percent in Slovakia. In comparison, US real GDP growth in the second quarter was 2.9 percent.
By expenditure category, here are growth rates for the components of real GDP in the Eurozone: Household spending was up 1.3 percent, business investment was up 2.8 percent, exports were up 3.2 percent, and imports were up 2.7 percent. By industry, manufacturing output was up 2.7 percent, construction activity was up 3.1 percent, information and communications were up 4.6 percent, financial services were down 0.2 percent, and professional services (such as Deloitte) were up 3.0 percent. Essentially, these data indicate that the Eurozone economy was driven strongly by exports of manufactured goods as well as business investment. Thus, the rising trade tensions with the United States represent a significant threat to economic growth in Europe. Indeed, manufacturing output has already decelerated significantly, having grown at a rate of 4.7 percent in the third quarter of 2017. Exports have decelerated as well, having grown at a rate of 6.5 percent as recently as the fourth quarter of 2017.
Week of September 03, 2018
Update on North American trade
Last week, after the United States and Mexico reached a bilateral agreement to revise the existing North American Free Trade Agreement (NAFTA) framework, the US administration said that it would give Canada three days to reach an agreement with the others and thereby create a trilateral deal.32 This did not happen. Rather, at the time of going to press, disagreements remain. Instead, talks are likely to continue this week, although the US side says it will submit the bilateral deal to Congress. In the absence of Canada’s agreement, the United States and Mexico say that they will go ahead with a bilateral deal.
President Trump said that the best alternative for the United States is to impose tariffs on Canadian automobiles.33 Treasury Secretary Mnuchin said, “We’ve made a lot of progress with Canada. Hopefully they’ll come on board but, if not, we’ll move on with Mexico.”34 The United States applied intense pressure on Canada to concede quickly or face a restrictive trade environment with its biggest trading partner. An end to free trade between the United States and Canada would likely be damaging to both countries, but especially to Canada. If the United States were to impose tariffs on imported automobiles from Canada, it would not only raise prices of cars, but could be hugely disruptive to automotive supply chains in North America.
At the same time, the US administration faces the potential for resistance from members of US Congress who represent states and districts that are dependent on trade with Canada. Such members are not likely to be supportive of a trade deal with Mexico that leaves out Canada. Thus, the administration might have an incentive to find common ground with Canada. In addition, American business groups have warned the administration that they will withhold support if Canada is not included. The US Chamber of Commerce said that “in order to do no harm to the 14 million US jobs that depend on trade with Canada and Mexico, the agreement must remain trilateral.” One of the big issues dividing the United States and Canada is trade in dairy products. The United States is demanding that Canada liberalize its protected dairy market. For its part, Canada is likely to seek changes to the part of the US-Mexico agreement that deals with domestic content for automobiles.35 Another issue of contention is that the United States and Mexico have agreed to scrap the existing dispute resolution process, while Canada has been adamant that it wants to retain this mechanism.36
Notably, it is not clear if President Trump can actually submit a bilateral deal with Mexico to the US Congress using the so-called fast track procedure under which the Congress is required to provide a simple up or down majority vote. The existing fast track mechanism was explicitly meant to apply to a revised NAFTA agreement. A new agreement that excludes Canada might not be relevant under this procedure (something that might need to be decided by the courts), in which case passage by the Congress becomes increasingly complicated. That is because members would be able to add amendments to the bill under question, and because there would be a 60-vote threshold in the Senate rather than a simple majority of 51 votes.
Not only is there concern among members of Congress that Canada was not included, but there is also concern about some specific aspects of the bilateral deal between Mexico and the United States. The terms to which some members of Congress object include a sunset provision that would require the deal to be renegotiated after 16 years; a weakening of the dispute resolution process; more restrictive domestic content rules for trade in automobiles; and a requirement that 40 percent of cars traded between the two countries be produced by workers paid more than US$16 per hour.37 In addition, some members of Congress expressed frustration that the administration has not provided more details about the deal reached with Mexico.
Italy at risk threatens Eurozone stability
While the Eurozone enjoys healthy economic growth, low inflation, declining unemployment, and low borrowing costs, it is worth asking what could possibly go wrong. Some analysts believe that the biggest risk facing the Eurozone is Italy’s new government. That is because some members of the new government, which comprises a coalition of a far left and a far right party, have expressed an intent to violate the fiscal rules of the European Union (EU). They believe that a fiscal stimulus can help to boost Italy’s economic growth. Yet the problem is that Italy’s government already has an unusually high level of debt, 29 percent of which will mature within one year. The government is expected to present its new budget at the end of September, and will formally submit it to the European Commission in mid-October.38
Many investors fear that, if Italy intends to borrow more than the Commission approves, there will be a conflict between the two. The consequence could be that bond yields skyrocket. If Italy then faces difficulty in financing its government, it may become necessary for the EU and the European Central Bank, and perhaps the International Monetary Fund (IMF), to step in and help—with conditions. This would be the Greek crisis all over again, but on a much bigger scale.
Already, investor fear is manifesting itself in a number of ways. Bond yields are very elevated, the risk premium between Italian and German government bonds is elevated, the cost of insuring Italian sovereign debt against default has soared, and there has been a massive net outflow of capital from Italy.39 Moreover, Italian banks hold a large share of the country’s sovereign debt. As the quality of that debt deteriorates, it has a negative impact on bank capital buffers. A reduction in bond prices (increasing yields) means that bank financial conditions deteriorate. This is known as the “doom loop.”40 Meanwhile, Italy’s business community is clearly concerned as evidenced by a sharp drop in business confidence.41
Rising US corporate profits
The US government reports that corporate profits increased strongly in the second quarter, especially after-tax profits, which were helped by the tax cut.42 The overall increase in profitability reflects the strength of the economy, but the after-tax increase largely reflects the big cut in corporate taxes enacted late last year. Specifically, before-tax profits were up 7.7 percent from a year earlier, taxes paid by corporations were down 33.4 percent, and after-tax profits were up 16.1 percent. The before-tax increase in profits was the biggest since 2016, while the after-tax increase was the biggest since 2012. This improvement in profitability goes a long way toward explaining the current frothy value of US equities.
Yet, so far, increased profits have not translated into a surge in corporate investment or an increase in wages. When the new tax law was being debated last year, advocates of a cut in the corporate rate made two claims—first, that higher after-tax profits would be shared with workers, leading to higher wages and more consumer spending; and second, that lower tax rates would cause businesses to spend more on capital investment. These things might still happen going forward, but they have not happened yet.
Wages are barely keeping pace with inflation, and the ratio of wages to profits has actually fallen. Business investment has not accelerated notably. Moreover, new orders for capital goods have not grown especially quickly. The purchasing managers’ indices for both manufacturing and services have also indicated a deceleration in activity.43 Thus, there is not yet evidence that the tax cut has boosted business spending. So, where is the extra money going? Some of it is going toward share buybacks and some of it is going into Treasury securities. The latter is needed to fund the extra borrowing by the government that will take place as a consequence of the tax cut.
Crisis in Argentina worsens
Argentina has slipped further into crisis. Despite having obtained a bailout from the IMF, the contagion from Turkey has infected Argentina and led to a sharp decline in the value of the peso, which fell sharply last week. Consequently, the central bank increased its benchmark interest rate from 45 percent to 60 percent, an increase of 1,500 basis points. The rout began after President Mauricio Macri asked the IMF to speed up the disbursement of cash, thereby signaling to investors that things could be worse than they thought. Macri said he undertook this effort in order to ensure investor confidence in the ability of Argentina to service its debts. Instead, this action led to a big increase in the cost of insuring Argentine debt against default.
Moreover, for the IMF to provide money more quickly than previously planned will entail new conditions. The IMF has agreed to speed up funding, with IMF Managing Director Christine Lagarde saying, “In consideration of the more adverse international market conditions, which had not been fully anticipated in the original program with Argentina, the authorities will be working to revise the government’s economic plan with a focus on better insulating Argentina from the recent shifts in global financial markets, including through stronger monetary and fiscal policies and a deepening of efforts to support the most vulnerable in society.”44
Meanwhile, the situation in Argentina evidently shook global investors and caused a spillover effect elsewhere. Currency values fell sharply in other emerging markets including Turkey, Indonesia, Brazil, and India. The decline of many emerging market currencies reflects not only contagion, but also the impact of a rising US dollar. There are two problems facing these countries. First, declining currencies can ignite inflation, thereby compelling central banks to raise interest rates and, consequently, slow economic growth. Second, declining currencies mean greater difficulty in servicing foreign currency debts. It is reported that roughly half of the world’s US$30 trillion in cross-border loans are denominated in US dollars.
A tale of two BRICs: India and Brazil
India appears to be recovering from the twin shocks of demonetization and implementation of the goods and services tax. Recall that, when these two events took place, the economy decelerated. Now the government reports that, in the second quarter of this year, real gross domestic product (GDP) was up 8.2 percent from a year earlier.45 This is the strongest GDP growth since the first quarter of 2016. The strong number partly reflects base effects—that is, growth a year earlier was quite weak, thus boosting the growth rate for the recent quarter. Although some analysts expect some deceleration in the next few quarters, there remains an expectation that growth will be strong. Looking at the demand side of GDP, exports were up a strong 12.7 percent while imports rose 12.5 percent. Investment was up 10.0 percent and consumer spending was up 8.6 percent. On the supply side, output was up 13.1 percent in manufacturing, 8.7 percent in construction, and 7.3 percent in the broad services sector.
Despite the strong economic growth, the Indian rupee has been under considerable pressure, falling to a record low against the US dollar.46 There are a number of reasons for this. First, the US dollar has been strengthening against most major currencies, and especially against emerging market currencies. Second, there is the contagion effect of trouble in such emerging markets as Turkey and Argentina. Third, oil prices have risen, causing expectations that India will face a larger external deficit. Fourth, the strength of demand in the economy is likely to fuel a large rise in imports, thus exacerbating the external deficit. A weaker rupee is good for export competitiveness, but it could exacerbate inflation, thus putting pressure on the central bank to raise interest rates.
Meanwhile, Brazil’s economy continues to decelerate. In the second quarter, real GDP was up only 1.0 percent from a year earlier, the slowest rate of growth since the second quarter of 2017.47 The weakness was partly due to the 10-day strike by truck drivers in May that hurt the distribution of goods. The result was weakness in consumer spending and a decline in exports. Specifically, household spending was up only 1.7 percent versus 2.8 percent growth in the previous quarter. Exports fell 2.9 percent while imports grew 6.8 percent. Thus, net exports made a large negative contribution to growth. On the positive side, fixed asset investment was up a strong 3.7 percent. Output in the manufacturing sector was up a modest 1.8 percent versus growth of 4.0 percent in the previous quarter. Construction activity declined 1.1 percent.
Overall, Brazil’s economy remains weak, even after taking account of the temporary strike. However, it is expected that growth will rebound somewhat in the next quarter. The currency has been declining in value, partly reflecting a lack of confidence that the government will successfully address its structural budget deficit. Although inflation remains muted, currency depreciation could lead to a rebound in inflation. This will hamper the ability of the central bank to further cut interest rates.
Meanwhile, the presidential election is coming soon. The most popular candidate is former President Lula da Silva, who is serving a prison sentence and is barred from running. The other top candidate is the far-right former army officer Jair Bolsonaro, who favors protectionist trade policies. There is fear is that he might isolate Brazil from the global economy and move the country in an authoritarian direction. The candidate most popular in the business and investment community is former Sao Paulo Governor Geraldo Alckmin, but he is polling poorly. There is no clarity as to who the winner will be, and thus there is uncertainty about the future direction of policy.
Australia: Political turmoil amidst plenty
David Rumbens, a partner at Deloitte Access Economics in Australia, offers his thoughts on the latest political and economic events down under.
After a week of turmoil, Scott Morrison became Australia’s 30th Prime Minister, the country’s sixth change in leader since 2007. Frictions in the governing Liberal-National Coalition reached fever pitch after disagreements over energy policy (incorporating emissions targets) took centre stage. The resulting leadership spill saw Malcolm Turnbull step down as prime minister, to be replaced by the former treasurer. In all, as the outgoing prime minister stated, climate change policy is “very hard” for the Liberal-National Coalition because it is treated as an ideological matter with “bitterly entrenched” views. This is true for Australia more broadly. It has been a decade of chopping and changing for the Australian energy policy, leading to uncertainty for businesses and a lack of necessary investment.
Despite a lack of direction over energy policy, the political change occurred at a time when the Australian economy is performing reasonably well (with GDP growth at 3.1% and the unemployment rate edging down to 5.3%). The latest Deloitte CFO Sentiment survey48 revealed that 77% of CFOs in Australia were either optimistic or highly optimistic about the financial prospects of their company.
While Australia’s domestic politics had a week it would rather forget, on the international stage the country continues its push for trade liberalisation. The new prime minister is expected to make his first official visit in the role this week to Indonesia where Australia and Indonesia will announce an in-principle agreement on a free trade deal. This comes in the same year Australia was a founding member of the rebooted Comprehensive and Progressive Agreement for Trans-Pacific Partnership, which is the Trans-Pacific Partnership agreement without the United States.