What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
The late Tip O’Neill, speaker of the US House of Representatives in the 1970s and 1980s, liked to say that all politics is local.1 Yet both President Trump and Democrats tried to nationalize Tuesday’s midterm elections, making the results to some extent a referendum on Trump himself.2 Interestingly, however, Trump did not emphasize the strong state of the US economy, much to the chagrin of congressional Republican leaders. Rather, he focused on issues—particularly immigration—that were expected to motivate his political base.3 Exit polls notwithstanding, it is too early to definitively say what motivated voters,4 but in the end, the result was a mixed bag for both parties—although Democrats gained on balance. Most significantly, Democrats took control of the House of Representatives for the first time in eight years, albeit by a modest margin. Republicans retained control of the Senate, where they boosted their small majority. Democrats picked up a number of key governorships, especially in the Midwest and Northeast, though they failed, by a narrow margin, to pick up key races in the South.
How can we assess this? On the one hand, the first midterm election of a president’s term usually results in losses for the president’s party.5 This indeed happened. On the other hand, a president’s party often does well in midterms when the economy is strong. This explains, at least in part, the fact that the “blue wave” for which many Democrats had high hopes did not materialize. As such, this midterm was very different from the Obama administration’s first midterm election in 2010, in which it suffered big losses. Many key races were very close, including many in which Republicans held onto seats that were seriously challenged. For example, Republicans held onto the governorship in Florida and a Senate seat in Texas, but by unusually small margins. This suggests that, in a different economic environment, Democrats might become quite competitive in previously inhospitable states such as Texas, Georgia, and Florida. Demographic changes have led many Democrats to look forward to the day when these states can be turned.6
What will all of this mean for policies? Democratic control of one house of Congress means that the White House cannot expect to easily achieve major legislation over the next two years. The Republicans would like to make last year’s tax cuts permanent; this will likely not happen. As for spending, it is unlikely that there will be a significant shift in the trajectory of spending, although it is possible that the two parties will agree to sustain high levels of spending that are currently set to decline in two years. On the regulatory front—at least, regulation that involves Congress as opposed to simply coming out of the White House—not much is likely to happen. As for immigration, the new Congress will not agree to fund (or to continue funding) the much-discussed wall with Mexico.7 Indeed, it is hard to imagine that the administration could agree with the Democrats on anything to do with immigration. At the same time, the administration could find common ground with the new Democratic majority in the House on such issues as infrastructure investment, paid family leave, drug prices, and raising the federal minimum wage. Yet even on these, finding support in the Republican-led Senate would likely be difficult.
The economic issue that has seen the most significant government actions in 2018 is trade, in large part because the president generally has the authority to act without congressional approval. That will remain true, and it is likely that the United States will continue to take harsh action against China, something that appears to be popular with voters across the political spectrum.
The one area of trade policy in which the new Congress could make a difference involves US trade with Mexico and Canada. The Trump administration has negotiated the US Mexico Canada Agreement (USMCA) as a replacement for the North American Free Trade Agreement (NAFTA), and it must be approved by both houses of Congress before becoming law. Passage is not guaranteed: While many Democrats agree with the administration’s protectionist bent, and many likely agree with the labor market rules of the new USMCA, it is possible that they will be averse to the agreement nonetheless, reluctant to hand the president a victory. They have learned what Republicans learned during the Clinton years: that is, Bill Clinton reached a number of key agreements with the Republican Congress, but Clinton got most of the credit. Thus, during the Obama years, the Republican majority in Congress chose not to reach deals with the president, even on issues, such as trade, on which they actually shared common ground; their goal was to avoid giving Obama the appearance of success.8 Democrats, after two years of pummeling by President Trump, may decide to deny him the appearance of success on the trade deal. If that happens, the original NAFTA will remain in place, unless the administration follows through with its earlier threat to exit NAFTA early in 2019. At the same time, Democrats might be willing to support the USMCA in exchange for something. Moreover, some Midwestern Democrats might be reluctant to reject the agreement on the fear that the alternative (no agreement) could be worse for their districts or states.9 Either way, businesses are likely to face a heightened degree of uncertainty about North American trade for at least the next few months.
Beyond economic policy, the composition of the new Congress means that the House will be in a position to implement serious investigations of the administration. This will entail subpoenas of key documents and public hearings in which administration officials will be compelled to testify under oath. At the least, such investigations have the potential to seriously distract lawmakers. That was the case in 1973–74 during the Watergate scandal, when the legislative process ground to a near halt.
Another important impact of the midterms is that, with the governorships of at least seven states—and control of a number of statehouses—switching to the Democrats, the party will have the opportunity to redraw more legislative districts following the 2020 census. Efforts to redo Republican-drawn district lines—Democrats ended up with a 6.9-point margin in House voting, but only a narrow margin in the chamber10—could improve Democratic prospects in House elections during the next decade.
For five years, Japan’s central bank has pursued an aggressive monetary policy meant to boost inflation. It involved negative short-term interest rates, massive purchases of government bonds, and targeting the yield on the 10-year bond. The policy was successful in that it ended persistent deflation, but unsuccessful in that it failed to boost inflation around the target of 2.0 percent. Still, the economy has benefitted from this policy. It weakened the yen, thereby improving the competitiveness of exports; it led to an increase in asset prices, thereby boosting consumer and business spending; and it ended deflation, thereby enabling real (inflation-adjusted) interest rates to be relatively low.11 That, in turn, stimulated consumer and business spending. The end result has been stronger growth, low unemployment, and a tight labor market with accelerating wages.
Now, Bank of Japan Governor Kuroda says that it might be time to adjust the policy.12 In the past year, he has already increased the target yield on government bonds and scaled back the pace of asset purchases. Now he says that Japan is “no longer in a stage where decisively implementing a large-scale policy to overcome deflation was judged as the most appropriate policy conduct.” Evidently Kuroda does not want Japan to be completely out of synch with the two other large developed-country central banks (namely, the US Federal Reserve and the European Central Bank), both of which have already shifted or are shifting toward tighter monetary policies. However, the risk is that a tightening of monetary policy before there are any signs of accelerating inflation will likely cause the economy to slow down. Moreover, the government is set to increase the national sales tax next year, which could have a negative impact on growth. Monetary policy is ordinarily tightened when there is a risk that inflation will get out of hand. That is hardly the case in Japan. The risk of maintaining an easy monetary policy is that, with historically low borrowing costs, asset prices will exhibit the characteristics of a bubble, and investors will likely not be sufficiently risk averse.
Kuroda noted that even though an easy monetary policy cannot go on forever, it will indeed go on for a while. Specifically, he said that he won’t tighten before the tax increase, and that an easy policy will last “for an extended period.” Moreover, he said that “prices have improved steadily compared with five years ago, when the economy was suffering from deflation. However, it has been taking time to achieve the price stability target of 2.0 percent. In such a situation where economic and price developments have been somewhat varied, it has become necessary to persistently continue with powerful monetary easing while considering both the positive effects and side effects of monetary policy in a balanced manner.”
One way to get a sense of the direction of the global economy is to examine the purchasing managers’ indices (PMIs) for manufacturing that are published by IHS Markit. These indices are meant to signal the direction of activity in the critically important manufacturing sector in multiple countries. They are based on sub-indices for output, new orders, export orders, input and output pricing, inventories, employment, and sentiment, among others. A reading above 50.0 indicates growing activity; the higher the number, the faster the growth—and vice versa.
IHS Markit has released the PMIs for October (see table) and they indicate that global growth of manufacturing activity continued to decelerate.13 The global PMI fell to a two-year low. This was largely due to a weakening of growth in Europe and China, but was partly offset by stronger growth in the United States and Japan. The PMIs indicated weakness in export orders in almost every country, partly due to protectionist concerns. In addition, many countries exhibited accelerating input prices, partly due to elevated energy prices, partly due to capacity constraints, and party due to increased tariffs, especially on metals.
Here are the details:
The PMI for the United States rose slightly to a five-month high, hitting a level indicative of strong growth. The sub-indices for new orders also hit a five-month high and the sub-index for employment hit a 10-month high. At the same time, new export orders were weak. In addition, both input and output prices accelerated, fueled in part by higher commodity prices and higher metals prices resulting from increased tariffs. With input prices rising faster than output prices, there was pressure on profit margins. Finally, Markit noted that, based on interviews with purchasing managers, “the key area of concern remained tariffs, which were widely reported to have contributed to another month of stalled export sales and a steep rise in prices for many inputs. Average input prices rose at one of the sharpest rates seen over the past six years in October.”
The PMI for Mexico fell to a level indicating very slow growth, with most of the sub-indices falling as well. Confidence hit a 21-month low. Uncertainty about the incoming administration may explain this. At the same time, the weak peso likely helped exports. In Canada, the PMI fell to a nine-month low as output and new orders weakened. However, an increase in spending in the energy sector likely helped to moderate the deceleration. Finally, in Brazil there was a slight improvement, with the PMI indicating modest growth. Markit noted that the PMI was held back due to political uncertainty. If the new administration pursues policies favored by manufacturers, it could have a positive impact on spending.
In Europe, the PMI for the United Kingdom fell sharply to a 27-month low. Growth of output decelerated, while new orders and employment actually declined. Export orders were especially poor. Survey respondents indicated that uncertainty about Brexit had a negative impact on orders from other EU countries. In the 19-member eurozone, the PMI fell to a 26month low, with Italy slipping into negative territory as activity actually declined. For the eurozone, there was an overall decline in new orders for the first time since 2014, led by considerable weakness in export orders that declined for the first time since 2013. Despite weak demand, input prices accelerated, due to increased energy prices and a weakened euro. Still, capacity constraints eased, and inventories rose.
The PMI for Poland fell to a two-year low, hitting a level indicating extremely weak growth in activity. There was weakness in new orders, led by the sharpest drop in export orders in six years. In Turkey, the PMI increased, but remained at a level indicating rapid decline in activity. The improvement, however, was likely due to the stabilization of the currency following a tightening of monetary policy by the central bank. Export orders fell sharply. In Russia, the PMI moved into positive territory for the first time since April, indicating modest growth in activity. Both output and new orders increased in October.
In Asia, India’s PMI rebounded as both new orders and export orders did well, and job creation hit a 10-month high. In China, the PMI rose only marginally, remaining at a level indicating almost no growth in activity. Although overall output and new orders expanded, export orders fell for the seventh consecutive month. Employment also fell. Still, input prices accelerated, rising at the fastest rate in nine months and putting pressure on profit margins. The uncertainty about trading relations with the United States likely bodes poorly for further export orders. In Japan, the PMI increased to a four-month high, hitting a level indicating moderate growth in activity. The rebound might be due to a recovery following natural disasters in September. In South Korea, activity continued to rise modestly, but at a slightly slower pace. Activity expanded, but export orders continued to fall. In Taiwan, the PMI fell into negative territory for the first time since May 2016. Weak output, new orders, and especially export orders were responsible. Taiwan’s large electronics industry is part of larger supply chains in Asia that have been hit by the uncertainty about trade. Concerns about trade wars hurt confidence about the future. Finally, in Southeast Asia, the PMI for the Association of Southeast Asian Nations (ASEAN) fell into negative territory as new orders fell by the most in two years. The highest PMIs in the region were for the Philippines and Vietnam. The lowest were for Singapore and Myanmar.
Here are the numbers:
In Brazil, the far-right candidate, Jair Bolsonaro, handily won the presidency as expected. His opponent, Fernando Haddad, only did well in the Northeast of the country. Ever since it became clear that Bolsonaro would likely win, Brazilian equities have risen and the currency has appreciated. Many investors have shown confidence that Bolsonaro will have a positive economic impact. Bolsonaro himself has been relatively vague about his economic plans. He recently said that the government should target the exchange rate, something most economists see as problematic given that a floating currency avoids the balance of payments problems of the past. During his long career in the Brazilian Congress, he has often taken stands in favor of statist policies.14
Yet Bolsonaro’s top economic advisor, Paulo Guedes, who is slated to be a major figure in the new administration, has offered a more free-market vision.15 First and foremost, Guedes says that there must be pension reform in order to put Brazil’s fiscal house in order. He also favors increased privatization of state-run businesses, reduced taxation, and freer trade with the rest of the world. If this agenda is implemented, it would justify the current confidence of investors. Yet there remains uncertainty. Bolsonaro himself has suggested that Chinese investment in Brazil is a problem, and that privatization should not take place in key sectors. He also contradicted Guedes’ statements on taxation. The real question now is the degree to which Bolsonaro will allow Guedes to act on his agenda.
Meanwhile, Bolsonaro’s flirtation with authoritarianism as well as his shocking comments about women, blacks, homosexuals, and other minorities has alarmed some observers. The outlook for Brazil, therefore, remains uncertain. At the same time, most forecasters expect the economy to accelerate in the coming year, regardless of policy. This, combined with support within the Congress, should give Bolsonaro the political capital he needs should he pursue a reformist agenda.
In Germany, Chancellor Merkel said that she will not seek another term in office in 2021 and that she will now resign as chairman of her party. This comes after her party, the Christian Democratic Union (CDU), performed very badly in regional elections in the state of Hesse. This sets the stage for a battle to replace her as the leader of the center right in Germany. It also means that, for the remainder of her time in office, Merkel is likely weakened. This will also likely make it more difficult for her to enter into politically controversial agreements with other countries. Moreover, there is already talk among CDU leaders about forcing Merkel out of office early.17 There is also talk about ending the grand coalition with the Social Democrats and possibly forming an unusual coalition with the Greens, which have risen in popularity.
As for the Social Democrats, they are also talking about walking away from their coalition with Merkel. In any event, in multiple recent elections in Germany, the center left and right parties have performed poorly, with the parties farther to the left and right boosting their share of the vote instead. Thus, German politics is becoming more fragmented, likely making it more difficult to form the kinds of coalitions that can govern effectively.
This is not only a German phenomenon. It appears to be happening in other European countries as well as in the United States where the two main parties are more stratified than ever. In the case of Hesse, which has been governed by the center-right for the last 30 years, the CDU saw its share of the vote fall by 11 percentage points since the last election. The center left Social Democrats also suffered a sharp drop in voter share. Instead, the Greens, far left, and Alternative for Germany, far right, saw their share increase.
The eurozone economy has decelerated considerably. The European Union (EU) reports that, in the third quarter of 2018, real gross domestic product (GDP) in the 19-member region was up 0.2 percent from the previous quarter and up 1.7 percent from a year earlier.18 Both figures are the slowest rates of growth since 2014. This came about as the Italian economy, the third largest in the eurozone, experienced no growth at all in the third quarter. The last time this happened was in 2014. Italy’s weakness is likely related to the standoff between the Italian government and the EU over the size of Italy’s budget deficit. The yield on Italian government debt has soared to the highest level since 2013, likely having a negative impact on business investment. Moreover, there is heightened uncertainty for Italian businesses.
Another factor that weakened eurozone growth was the introduction of new automotive emissions standards in Germany, which had a negative impact on automobile production.19 In addition, other factors that hurt growth were the rise in energy prices over the past year and the weakening of exports as a consequence of trade tensions. At the same time, it is reported that GDP growth in France accelerated in the third quarter to 0.4 percent, stronger than the 0.2 percent growth in the previous two quarters. Thus, there is debate20 as to whether the overall slowdown in the third quarter was mainly due to transitory factors or whether it signaled a further enduring slowdown in European growth.
For the European Central Bank (ECB), this is an important question, the answer to which will determine the direction of monetary policy. The ECB has already decided that it will end bond purchases at the end of this year, although it intends to keep interest rates low. Then end of asset purchases could result in a rise in bond yields beyond their current level. Moreover, the latest data from Germany shows headline annual inflation in October at 2.4 percent, well above the ECB’s target.21 This surely provides justification for the shift in monetary policy. Meanwhile, ECB President Draghi has said that the eurozone is not at risk of a substantial slowdown, thus indicating his disposition to continue along the path of policy normalization. The euro fell on news of slower GDP growth.22
The US jobs market is red hot. The latest reports from the US government indicate continued rapid employment growth and a significant acceleration in wages. There are actually two reports produced by the government: one based on a survey of establishments, and the other based on a survey of households.
The United States is planning to impose new tariffs on Chinese imports if a planned meeting between US President Trump and Chinese President Xi is not successful in generating a new trade agreement.26 There is talk of imposing tariffs on all remaining imports from China. So far, the US has imposed tariffs on about half of US imports from China. Recently, a 10 percent tariff was imposed on US$200 billion in imports, and this is scheduled to rise to a 25 percent tariff in January in the absence of a new trade agreement. Previously, the United States had imposed tariffs on US$50 billion in imports. There are roughly US$257 billion in imports that are not currently subject to new tariffs, but these are the imports that might be targeted in the absence of a new trade deal.
China has already imposed retaliatory tariffs on US$110 billion in imports from the United States, leaving little room for China to impose further tariffs. Rather, China is likely to retaliate against new US tariffs by imposing new non-tariff barriers.27 Many US businesses are beginning to plan for higher prices of imported goods, less competitiveness for exports to China, and disrupted supply chains. Analysts expect that a new round of tariffs will significantly boost consumer prices in the United States, leading to a temporary surge in inflation. It is also reported that many global companies currently producing goods in China for export to the United States are planning to shift assembly to other Asian countries. News of the planned tariffs immediately led to a drop in US equity prices,28 with an especially sharp drop for companies that are highly exposed to China.
Meanwhile, any expectation that the United States and China will reach a new deal before the end of the year has been squelched. White House economic advisor Larry Kudlow poured cold water on this expectation, saying, “We’re not on the cusp of a deal.”29 If there is no deal, the existing 10 percent US tariffs on US$200 billion in imports from China will rise to 25 percent in January.
Incoming Mexican President Andre Manuel Lopez Obrador, also known by his initials AMLO, has decided to cancel the construction of a new US$13 billion airport for Mexico City.30 The construction began three years ago and is about one-third complete. It has been funded by bonds issued by the government. The surprise move by AMLO left investors worried about the value of those bonds and, more importantly, about the reliability of government commitments and the future direction of economic policy. The result was a sharp drop in the value of the peso and in the prices of Mexican equities. This controversy began when AMLO commissioned a “citizen’s vote” whereby a private polling company held a public referendum in which about 1 million people participated. AMLO said that the results, in which a two-thirds majority voted against the airport, will drive policy.
The cancellation led to a sharp drop in the value of bonds. This is a concern for pension funds that invested significantly in the airport bonds. In addition, the drop in equity prices and the peso reflected investor concern that the government will likely act in arbitrary ways that put investments, including inbound investments, at risk. As a result, JP Morgan downwardly revised its forecast for Mexican economic growth in 2019 by 0.5 percentage point.
As for air travel, the government says that it will address the issue of inadequate capacity at Mexico City’s existing airport. Specifically, it intends to improve the existing airport, add two runways to a military airport, and improve a nearby airport.31 Yet the new modern airport, designed by famed architect Sir Normal Foster, was seen as needed to create a more efficient hub for transportation in one of the world’s most important emerging markets. At a time when other big emerging markets, such as China, India, and Turkey, have built or are building major new airports, Mexico was seen as catching up. Now, that will not be the case.