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The recent resurgence of the COVID-19 virus in parts of Europe is evidently taking a toll on the services sector. The latest flash purchasing managers’ index (PMI) for services in the eurozone fell sharply in September, indicating a decline in services activity. PMIs are forward-looking indicators meant to signal the direction of activity in both services and manufacturing. They are based on a variety of sub-indices. A reading above 50 indicates growing activity; the higher the number, the faster the growth, and vice versa. The latest services PMI for the eurozone fell from 50.5 in August to 47.6 in September—a number indicating a moderate decline in activity. On the other hand, the manufacturing sector continued to improve, with the PMI increasing from 51.7 in August to 53.7 in September, a 25-month high. The weakness in services likely reflects the fact that due to the revival of the virus in some locations (especially in Spain and France), many consumers are increasingly avoiding social interaction in ways that diminish spending on services. This led to a decline in employment in service industries. On the other hand, the European Union (EU) reported that consumer confidence in the region increased in September despite the surge in cases. The strength of manufacturing likely indicates growth of global demand for eurozone exports as well as internal demand for durable goods.
In the United Kingdom, the PMI for services fell slightly but remained at a level indicating strong growth. Evidently the data was obtained prior to the recent outbreak of the virus, which is only now starting to take a toll on the British economy, especially with the government ordering new restrictions. Meanwhile, the flash PMIs for Germany and France show that they both followed the same pattern as the larger eurozone, with a sharp decline in their services PMIs but an improvement in manufacturing.
Going forward, the path of both the eurozone and the UK economies will depend heavily on the path of the virus, as well as on the fiscal policy responses of various European governments. The British government is now considering extending stimulus in view of the difficult road expected in the months to come. The German government has already extended stimulus. On the positive side, the European Central Bank reported that the increase in consumer saving in recent months in the eurozone was mainly due to lack of spending opportunities. This suggests that many consumers have plenty of cash and a lot of pent-up demand. This bodes well for a revival of spending once consumers are less worried about the virus.
Michael Wolf, a global economist with Deloitte Touche Tohmatsu Ltd., provides an analysis of the latest high frequency data on the European economy:
The COVID-19 outbreak is worsening in Europe. The number of new cases has been rising quickly in Spain and France since the end of July. Germany and Italy have seen only a very modest rise over that period, while the number of cases in the United Kingdom began to climb notably higher at the beginning of September. The outbreak is weighing on economic activity as the newly released European PMIs for services show. However, the relationship between this measure of economic activity and the number of confirmed cases has changed since the spring. The second wave of cases in Spain and France has elicited a proportionally smaller contraction in economic activity than the first wave. Similarly, the relationship between confirmed cases and mobility these two countries also weakened over the summer as policymakers and individuals seem to have reacted more modestly to the recent rise in infections.
Although the size of economic contraction in Europe may be smaller this time around, activity is clearly slipping in the most affected areas. For example, box office sales have largely mirrored the outbreak of the virus. Spain and France posted the largest average weekend box office declines between August and September, with sales slipping by 67% and 31% respectively. At the same time, Germany and Italy posted huge box office gains of 70% and 170% respectively. In the United Kingdom, where infection rates are rising but not as dramatically as they are in Spain and France, box office sales increased by a mere 1.2% over the same period.
Flight traffic data has presented a similar story. The number of flights going in and out of Spain relative to last year has fallen dramatically. On August 7, flights to and from Spain were down 48.7% from a year earlier but were down 64.6% as of September 22. The relative fall in flights was about half as much in France and Italy as it was in Spain. In Germany, the number of flights worsened by just 4 percentage points from its summer peak, while in the United Kingdom it worsened by about 2 percentage points.
Despite the rapidly rising number of cases in Spain, tourism improved from July to August, with occupancy rates rising. However, the number of overnight stays was still 64% lower than a year earlier. In Italy, estimates suggest foreign tourism was down 70% year over year in August. The lack of foreign tourists at these popular vacation destinations has left inland cities and their tourist attractions particularly empty as domestic tourists opted for coastal vacations. In the United Kingdom and in Germany, dining is returning to normal for now. More than 90% of sampled restaurants in the United Kingdom and 100% of sampled restaurants in Germany are taking reservations via OpenTable. Both countries saw the number of seated diners rise above last year’s levels during weekends in September. However, with new restrictions on dining in place in the United Kingdom, the number of seated diners may begin to fall below previous year levels again.
Despite a weaker negative reaction to this second wave of infections in Europe, the rise in Covid-19 cases is restraining Europe’s recovery. As the weather gets colder, economic activities that were conducted outdoors over the summer will become considerably higher risk as they will need to be moved inside.
One of the strongest parts of the US economy in recent times has been the housing market. It was recently reported that in August, sales of existing homes increased sharply, hitting the highest level since 2007. Sales were up 2.4% from July to August and 10.5% higher than a year earlier. The strong US housing market reflects historically low borrowing costs. In addition, there are many anecdotal reports of people choosing to leave cities and obtain bigger suburban or rural homes in order to better telecommute. The impetus to do this is strong among relatively affluent households. Thus, it is not surprising that sales of homes priced at more than US$1 million were up 44% from a year earlier. Meanwhile, it was reported that the median sale price of existing homes was up 11.4% from a year earlier. This was due to strong demand combined with limited inventory. Moreover, construction costs have risen owing to much higher lumber prices. However, prices of lower-priced homes actually fell, reflecting weak economic circumstances for lower-income households. Prices of homes under US$100,000 fell 20% while homes priced between US$100,000 and US$250,000 fell 8.9%. The National Association of Realtors, which compiled the data, predicted that the overall demand for homes will continue to rise because many people expect to work remotely for a sustained period of time. The strength of the housing market is likely to spill over into strong demand for home-related products such as furniture and appliances.
Meanwhile, sales of new homes soared in August, hitting a level not seen since 2006. Specifically, the number of new homes sold in August was 4.8% higher than July and 43.2% higher than a year earlier. After a long period in which the housing market dragged down the larger economy, we are now in a period in which housing is one of the few areas of strength for the US economy.
Jay Powell, the chairman of the Federal Reserve, warned that the US economy could soon face significant headwinds due to the expiration of fiscal stimulus. He urged the US Congress to pass another stimulus package to protect households and businesses. His warning comes at a time when data suggests that the US economy is doing reasonably well, with employment rising and retail sales now higher than a year earlier.
However, Powell said this could lead to unwarranted optimism. He noted with the expiration of stimulus programs—which included enhanced unemployment insurance and loans to small businesses—any meaningful boost to spending will soon disappear. He said although consumers will initially dip into their savings and take on debt, eventually they will have to cut spending. In the process, they will cause economic activity to decelerate or decline. Despite his plea, it currently appears unlikely that the Congress and the White House will reach an agreement on stimulus any time soon. In the absence of such stimulus, the burden of boosting economic activity falls on the Federal Reserve. However, while monetary policy is good at dealing with credit market conditions, it is not good at channeling money to households and businesses. Powell said, “The recovery will go faster if we have both tools (monetary and fiscal policy) continuing to work together.” Meanwhile, The Financial Times reported that a survey indicated 90% of US households are pessimistic about US economic recovery. If true, this could bode poorly for a pickup in spending.
While Europe appears to have suffered a deceleration in services activity this month, the latest PMIs for the United States indicate that so far, the US economy has avoided negative consequences from the expiration of stimulus. In fact, the number of new infections in the United States, after having soared during the summer, has declined lately, possibly boosting economic activity. Specifically, the services PMI for the United States went from 55.0 in August to 54.6 in September, a marginal change and a level indicating relatively strong growth of activity. The separate manufacturing PMI increased from 52.7 in August to 53.3 in September, a number indicating moderate growth. The strength of the services PMI reflected strong demand and rising employment.
Yet, IHS Markit, the British information provider that compiles the data, said, “The question now turns to whether the economy’s strong performance can be sustained into the fourth quarter. COVID-19 infection rates remain a major concern and social distancing measures continue to act as a dampener on the overall pace of expansion, notably in consumer-facing services.” Indeed, as the winter months approach, there is concern that the virus could surge again due to people spending more time indoors. Moreover, the recent expiration of stimulus will likely lead to a downturn in consumer spending growth once consumers exhaust savings and access to debt.
The latest flash PMIs for Japan indicate that the Japanese economy is still not growing. Specifically, the services PMI went from 45.0 in August to 45.6 in September. This means that activity continued to fall at a moderate pace. The separate manufacturing PMI fell from 45.8 in August to 45.2 in September, also indicating a continued decline. This suggests a very weak third quarter for the Japanese economy following a catastrophic decline in the second quarter. On the positive side, the sub-indices for employment and sentiment both improved, suggesting the possibility that things will improve in the months ahead. Despite not having a major outbreak of the virus, Japan has been hobbled by weak domestic and foreign demand as well as disruption of global supply chains. The country’s new prime minister has pledged to focus on regulatory reform in order to jumpstart productivity growth.
During 2020, the relationship between the United States and China has become more contentious. In the United States, there is an increasingly bipartisan view that the United States must address perceived challenges from China, including alleged unfair trade practices, alleged failure to protect intellectual property, and alleged national security concerns related to globally traded technologies that originated in China. Consequently, businesses and governments on both sides of the Pacific Ocean appear to be preparing for a world in which there is less trade and cross-border investment. Such preparation, in part, entails shifting supply chains so as not to be excessively dependent on the bilateral relationship. Despite this situation, the Chinese government continues to encourage inbound investment by US companies, and many US companies appear to remain committed to participating in the Chinese market. Still, there is quantitative evidence that the relationship is changing.
In the first six months of this year, two-way capital flows between the United States and China fell to their lowest level since 2011. Capital flows were down 16.2% from the same period in 2019 and down roughly 75% from 2016-17. Specifically, US investment in China fell 31% in the first half of 2020 versus a year earlier. Yet Chinese investment in the US increased 38%—mainly due to a Chinese acquisition of a US-based entertainment company that accounted for 72% of Chinese investment in the United States.
This data is based on a review of two-way investments, such as foreign direct investment and venture capital investment, conducted by the National Committee on US-China Relations. There were several likely reasons for the sharp decline. First, the global pandemic led to a sharp economic downturn and increased uncertainty, thereby reducing business investment in general, which included cross-border investment. Second, the tense trade relationship between the United States and China led businesses to hold back on trade-related investment. Third, the United States has sought to restrict Chinese investment in the United States and the sale of US technology to Chinese companies. Such actions directly limited investment and probably contributed to wariness on the part of companies interested in cross-border investment.
Still, China continues to encourage inbound foreign direct investment on the part of US companies. In addition, China has liberalized its financial sector, leading to increased US financial services interest in China. Several large US-based financial services companies are eager to tap into China’s rapidly growing market for wealth management. Thus, the situation remains somewhat fluid. Going forward, much will depend on the political relationship between the two countries. That, in turn, will partly depend on the outcome of the US presidential election.
Meanwhile, global investors are evidently optimistic about China. Inbound foreign direct investment was up a strong 18.7% in August versus a year earlier. The government has encouraged this inflow of capital as part of its effort to create a larger and more sophisticated capital base with which to generate future growth. Also, the government reported that Chinese banks increased lending by 29% from July to August. Lending to business was up a stunning 119%. The increasing demand for credit reflects the growing confidence of businesses about the state of the Chinese economy. It also reflects the easing of credit conditions by the People’s Bank of China, China’s central bank. It is likely that the surge in business demand for credit could lead to an acceleration in investment. That said, the five biggest banks in China report that profits have fallen sharply due to an increase in bad loans.
Regarding supply chain risk, some companies and countries are starting to think about the risk of excessive dependence on China. For example, as part of its emergency increase in spending meant to offset the negative impact of the crisis, the Japanese government included a provision whereby Japanese companies can obtain government assistance to make their supply chains more resilient. Specifically, they can obtain help to move facilities out of China either back to Japan or to other countries. Japanese Prime Minister Abe said, “Due to the coronavirus, fewer products are coming from China to Japan. People are worried about our supply chains. We should try to relocate high addedvalue items to Japan. And for everything else, we should diversify to countries like those in ASEAN.”
Moreover, three major Asia Pacific nations have launched an initiative meant to achieve supply chain resilience. Specifically, the governments of Australia, India, and Japan agreed to investigate ways to avoid excessive dependence on China. There are few details offered about this initiative, and it remains unclear what can be accomplished. Still, the fact that they have launched this initiative is indicative of the fear that the status quo is not sustainable.
In addition, there is growing bipartisan support in the United States for encouraging a shift in supply chains out of China and back to the United States. Over the span of the post-war era, it was usually the case that one or both of the two major US political parties were largely supportive of freer trade and cross-border investment. The current US administration has taken the country in a different direction, imposing tariffs and urging US companies to bring jobs back to the United States. President Trump has made the loss of jobs to China a campaign issue and said that, under former Vice President Biden, the United States would continue to lose jobs to China. In response, the Democrats are walking a fine line, criticizing the president’s tariffs while suggesting that the US government ought to take steps to prevent the loss of jobs to China. Consequently, former Vice President Biden has recently proposed that US companies pay higher taxes on foreign earnings if those companies produce goods overseas for sale in the United States. This surtax would be on top of higher corporate taxes that he has proposed. In addition, he would offer a tax credit to US companies that invest in domestic production. Currently, the tax on corporate income is 21%, down from 35% before Trump’s tax plan was implemented. Biden has called for the base rate to be increased to 28%.
The Biden plan is merely a proposal and is not likely to be enacted in its entirety. Still, a campaign proposal does provide an indication about the direction that policy is likely to follow if Biden is elected.
Finally, it appears that many US companies are reluctant to participate in further fraying of the relationship. A survey conducted by the American Chamber of Commerce in Shanghai found that 70% of respondents have no intention of exiting China and only 4% are relocating processes to the United States. The president of the chamber said that “American companies still see China’s consumer market as a great opportunity.” This is not surprising. China is the world’s second largest economy with the world’s largest population and its economy has rebounded more sharply than any other major economy. Thus, despite tariffs and threats of more, these companies evidently see China as a profitable and important place to be. At the same time, the survey also found that the deteriorating relationship between the United States and China is the biggest concern of American companies in Shanghai. The risk is that these companies could get caught in the crossfire. If the United States takes further protectionist action against China, and China retaliates, it could make life difficult for US companies operating in China. That, in turn, could create a competitive advantage for non-US foreign companies, such as those from Europe or Japan.
In the past three decades, much of the developed world has experienced historically low inflation, low interest rates, stagnant wages, and rising income inequality. These trends were, in part, driven by global demographics as well as the rise of China. That is, demographics in developed economies (declining populations or declining working age populations) reduced the growth of demand. Meanwhile, an increasing supply of cheap labor from China and other emerging countries that entered the global economy increased supply and reduced costs. The result was low inflation which, in turn, contributed to low interest rates. Rising labor force competition from low-wage economies suppressed labor bargaining power and pushed down wages, especially of workers with relatively fewer skills. That, in turn, contributed to rising income inequality in affluent countries. That, in turn, might have contributed to rising populism and social unrest. The conventional wisdom is that these trends will continue in the years to come.
However, a new book suggests otherwise. The Great Demographic Reversal, by Charles Goodheart and Manoj Pradhan, says that some of trends are on the verge of reversing. That is, the 30-year surge in the world’s labor supply is about to end, especially as China ages and its working age population declines. Moreover, declining populations in developed economies will persist, thereby reducing the supply of labor. The result could be an acceleration in wages, thereby fueling higher inflation while, at the same time, reducing income inequality. That, in turn, might reduce the populist instinct of voters. Higher inflation will imply higher interest rates, which could create problems for a world awash in debt.
If the authors are correct, this has significant implications for business. Corporations in developed countries have become accustomed to an environment of stagnant wages for less-skilled workers, low inflation, and low borrowing costs. In the world suggested by the authors, businesses will have to adjust to higher wages for lesser skilled workers. This might compel them to invest more in labor-saving technology, thereby boosting productivity growth. There might also be more political support for investing in human capital and boosting the average skill level of the workforce. Businesses will have to adjust to higher inflation, which could boost profitability but also reduce the ability of price movements to provide useful signals about market conditions. High inflation is often accompanied by less efficiency. And businesses will have to adjust to higher capital costs, perhaps leading to more efficient use of capital and more attention to the most productive investments. However, businesses that are highly indebted might find a higher-interest-rate environment to be troublesome. While we cannot know if these predictions are accurate, they are certainly food for thought.
Debapratim De, senior economist with Deloitte UK, provides an explanation of the latest events surrounding Brexit.
Since the United Kingdom’s formal departure from the European Union in January, its relationship with the European Union (EU) has been governed by a transition agreement reached last year. The deal ensures minimal change, allowing continued free movement of goods and people, until December 31, by when both parties are to negotiate a future relationship.
While the stated objective of the British government has been to thrash out a comprehensive free trade agreement over this 11-month period, many analysts and trade experts saw a “thin deal” as the likely outcome, given the short time frame. Such a deal would enable tariff-free goods trade but substantive agreements on services trade or cross-border data flows would have to wait.
However, developments over this month have thrown that outcome into serious doubt. The British government has introduced into Parliament a bill that, if passed into law, would contravene a section of last year’s transition agreement called the Northern Ireland Protocol. The aim of the protocol is to avoid the return of a hard border, with customs checks between Northern Ireland, which is a part of the United Kingdom, and the Republic of Ireland, a EU member, should the transition period end in a “no-deal” Brexit—where the United Kingdom and EU part ways without an agreement, resorting to trade under World Trade Organization rules. In that event, the protocol keeps Northern Ireland in the EU’s single market for goods, unlike the rest of the United Kingdom, possibly until a future trade deal is struck. Therefore, it also sets out restrictions and processes governing the trade of goods between Northern Ireland and the rest of the United Kingdom, in the absence of a bilateral agreement.
The bill introduced in Parliament gives British policymakers the power to overrule some of these restrictions and ignore stipulated processes. Critics from several quarters, including former prime ministers, have pointed out that this legislation could undermine trust in the United Kingdom and damage its international standing. But the government argues that these powers are necessary to avoid, in the event of a “no-deal” Brexit, a customs border between Northern Ireland and the rest of the United Kingdom, which it sees as a threat to Britain’s integrity.
Some have suggested that this is a tactic to reduce European leverage in the ongoing negotiations, by limiting “no-deal” disruption. The government describes this as a necessary “insurance policy” for a potentially disruptive Brexit. Whatever the motivations behind this action, it has raised the risk of a deal-less and acrimonious departure from the EU, one with possibly serious implications for Britain’s relationship with its closest trade partner.
Regardless of the nature of Brexit, three changes for businesses are certain: a new immigration regime, new customs requirements and increased frictions in trade. In addition to preparing for these changes, businesses are likely to stockpile goods, in anticipation of disruptions, as they did in the run up to the March Brexit deadline last year. This should provide some support to growth in the fourth quarter, while destocking and abrupt change, in the case of a “no-deal” Brexit, would act as a drag on activity in the first quarter of next year.
If we do see a “no-deal” exit, the impact on supply chains and cross-border goods trade is likely to be concentrated in the first half of 2021, as businesses adapt to an immediately distant relationship with the EU. On thornier, and perhaps bigger, issues such as services trade, cross-border data flows and mutual recognition of standards, it is the nature of the divorce, whether amicable or acrimonious, that will determine the enthusiasm and willingness to reach a resolution. Ever since the Brexit referendum in 2016, it has been apparent that the United Kingdom could end up with a very distant relationship with the EU. Developments in the last few weeks make that a more likely outcome.
When US government stimulus programs expired at the end of July, there was an expectation that this would have negative economic consequences. Yet when the government reported relatively strong employment numbers for August, many observers interpreted this to mean that the expiration of stimulus had not been so bad after all. Indeed, the argument made by some in Congress who opposed further stimulus was that the economy is doing fine without more stimulus. Last week, however, the US government reported that retail sales decelerated in August, perhaps offering the first piece of evidence that the expiration of stimulus will indeed have negative consequences. For several months until the end of July, the US government provided a US$600 per week supplement to unemployed Americans. When this ended, it had a negative impact on personal income and, consequently, on spending.
Specifically, retail sales in August were up 0.6% from July, compared to an increase of 0.9% in the previous month. Moreover, non-auto retail sales increased 0.7% compared to 1.3% in the previous month. By retail category, sales were up 0.8% at electronics and appliance retailers compared to an increase of 20.7% in the prior month. In addition, sales declined 1.6% at grocery stores versus an increase of 0.7% in July. Sales were down 2.3% at department stores compared to an increase of 2.0% in July. Finally, sales were unchanged at non-store retailers compared to an increase of 0.3% in July. At the same time, sales growth was strong in August for apparel retailers, furniture retailers, and restaurants.
The deceleration in August was modest. Although personal income likely declined, it is also likely that many consumers dipped into their savings and/or boosted credit card debt in order to smooth spending. Yet, over time, this will be less feasible. If the Congress does not pass any further stimulus (and it now seems unlikely that it will), and if the number of unemployed remains high, it is reasonable to expect further weakness in consumer spending.
There is now a raging debate about the long-term consequences of the behavioral changes attributable to the virus. Specifically, there is debate about the potential impact on productivity and growth if a large number of people continue to work from home even after the crisis is over. The OECD, which is effectively the club of developed nations, has conducted research on this topic. The economists at the OECD note that, on the one hand, telecommuting “promises to improve work-life balance and may raise worker efficiency and lower costs for office space.” In other words, workers can get more done, in less time, and using fewer physical resources. That sounds like an increase in productivity. On the other hand, the OECD says that the potential impact on productivity remains ambiguous. That is because telecommuting “entails possible adverse effects as it impairs communication, social interactions and may slow down innovation, or may lead to hidden overtime, shifting costs on employees and solitude.” In other words, people need people in order to be innovative. Online technology might not be sufficient to generate the kinds of interactions that engender creativity. Moreover, the OECD says that “the lack of personal interactions can decrease knowledge flows among workers.” It also says that the ability to manage workers is diminished when people are not present.
So, what is the optimal mix of telecommuting and working at an office? The OECD attempts to answer this question by offering guidelines for policymakers. Specifically, it said that, “to minimize the risks of more widespread teleworking harming long-term innovation and decreasing worker well-being, policymakers should assure that teleworking remains a choice and is not ‘overdone’; co-operation among social partners may be key to address concerns.” That said, the OECD also suggested that policymakers can do things to accelerate the productivity gains that come from telecommuting. It said, “To improve the gains from more widespread teleworking for productivity and innovation, policymakers can promote the diffusion of managerial best practices, self-management and ICT skills, investments in home offices, and fast and reliable broadband across the country.”
The OECD notes that, even prior to this crisis, a fairly large number of people were already working remotely. The crisis merely accelerated this trend. It found that, prior to the crisis, the Nordic countries had the highest share of people working remotely, followed by the United States. The countries of southern and central Europe, as well as Germany, were among those least likely to engage in telecommuting. By industry, the highest share of workers engaged in telecommuting were in knowledge-intensive services (such as Deloitte), while the lowest share—not surprisingly—was in manufacturing. Also not surprisingly, those most likely to have engaged in telecommuting were those with the highest level of skill and education. With the virus, however, these patterns have been significantly exacerbated. Surveys indicate that, going forward, many companies expect to keep large numbers of people working remotely even after the crisis ends.
For my part, I was mostly working remotely even before the crisis, not often going to the Deloitte office in Los Angeles. However, I also traveled a lot—clocking roughly 250,000 miles per year in order to meet with colleagues and clients. While telecommuting now enables me to conduct similar meetings, I don’t have the opportunity to chat over coffee or go out for lunch or dinner. It is that informal communication that used to allow me to ask questions, answer questions, engage in banter, and yes, even gossip. Without that, it is more difficult to generate, share, and absorb ideas. It seems to me that, in the future, while telecommuting will surely have a place, in-person interaction will be critically important as well.
Meanwhile, investors are trying to figure out what is happening. The share prices of technology stocks fell sharply last week as some investors took the view that people will soon return to normal behavior as the economy recovers and the virus fades, including more social interaction and less online interaction. Nonetheless, given the uneven recovery of the global economy and the continued suppression of demand for energy, oil prices have fallen sharply on the view that the economy still has some way to go before resumption of normal activity.
The Commodity Futures Trading Commission (CFTC), which is the US government agency responsible for regulating trading of commodities and futures contracts such as derivatives, issued a report that offered a bleak assessment of the future of US finance. The report was prepared by an advisory panel that consisted of major financial institutions that endorsed the report unanimously. Specifically, the CFTC advisory report began by stating the following: “Climate change poses a major risk to the stability of the US financial system and to its ability to sustain the American economy. Climate change is already impacting or is anticipated to impact nearly every facet of the economy, including infrastructure, agriculture, residential and commercial property, as well as human health and labor productivity. Over time, if significant action is not taken to check rising global average temperatures, climate change impacts could impair the productive capacity of the economy and undermine its ability to generate employment, income, and opportunity. Even under optimistic emissions reduction scenarios, the United States, along with countries around the world, will have to continue to cope with some measure of climate change-related impacts.”
The report suggested that climate change could wreak havoc with financial markets by causing “disorderly price adjustment” as well as by disrupting the “proper functioning of the financial system.” Moreover, not only is climate change itself expected to be disruptive, the process of rectifying climate change could also be disruptive. In addition, the report noted that “a major concern for regulators is what we don’t know.” That is, the report noted that we don’t know much about how quickly things will change or what interactions there will be between different types of climate change. It suggested that regulators act decisively to better understand what they face and how to react. It also suggested that financial institutions not only be reactive but proactive. Specifically, it said that “financial innovations, in the form of new financial products, services, and technologies, can help the US economy better manage climate risk and help channel more capital into technologies essential for the transition.” One way to better achieve these goals is to have a robust market for carbon trading in which carbon is priced appropriately. It said that “in the absence of such a price, financial markets will operate sub-optimally, and capital will continue to flow in the wrong direction, rather than toward accelerating the transition to a net-zero emissions economy.”
Finally, the report emphasized the importance of having companies reveal “information on material, climate related financial risks” so that regulators and investors can accurately assess the value of a company’s securities. It also called for other regulatory bodies to incorporate climate risk into their calculus when making regulatory decisions. At a time when the US administration is downplaying and dismissing climate risk, and even attempting to stop pension funds from investing with climate concerns in mind, this report is notable for pushing the US government in a different direction. Interestingly, it reflects a strong consensus among financial institutions, including banks, investment firms, insurance companies, and energy traders, that were part of the advisory panel.
Global investors are evidently optimistic about China. Inbound foreign direct investment was up a strong 18.7% in August versus a year earlier. The government has encouraged this inflow of capital as part of its effort to create a larger and more sophisticated capital base with which to generate future growth. Meanwhile, the government also reported that Chinese banks increased lending by 29% from July to August. Lending to households was up 11% while lending to business was up a stunning 119%. The increasing demand for credit reflects the growing confidence of businesses and households about the state of the Chinese economy. It also reflects the easing of credit conditions by the People’s Bank of China (PBOC), China’s central bank. The PBOC has cut interest rates, reduced bank reserve requirements, and provided direct loans to companies disrupted by the virus. It is likely that the surge in business demand for credit will lead to an acceleration in investment, and possibly an increase in equity and corporate bond issuance. At the same time, the five biggest banks in China report that profits have fallen sharply due to an increase in bad loans.
The surge in credit activity and inbound investment is consistent with measures of real economic activity, which indicate that China is likely in the midst of a V-shaped robust recovery. After falling sharply in the first quarter, real GDP surged in the second quarter and is likely growing at a good pace in the third quarter. However, what is increasingly clear is that much of that growth is driven by government investment in infrastructure and that underlying private sector demand is not commensurately strong. For example, in August, sales of construction excavators were up 51.3% from a year earlier. Sales of heavy trucks, many of which are used for construction, were up 75% versus a year earlier. Meanwhile, some other broader measures were not as impressive. For example, sales of automobiles were up 6%. Also, Premier Li has said in the past that, rather than examine government data on the economy, he prefers such measures as freight rail volume and electricity consumption. Both are doing well, but not stellar. Freight rail volume was up 7.3% in August versus a year earlier, indicating that the economy is operating at a strong pace. Electricity consumption hit a record level in the first days of August. These are good numbers, but not consistent with the numbers that reflect activity in construction. Meanwhile, the government reports that spending at restaurants and hotels remains weak, an indication that the continued fear of the virus is deterring consumers from spending in ways that involve social interaction. Overall, it appears that China is doing better than most other major economies. However, China continues to face risks. These include trade tensions with the United States, weak overseas demand, an increase in the volume of bad debts held by Chinese banks, and weak consumer demand for services.
With the US administration talking about decoupling from China, the risk to China is that its fast-growing technology sector will lose access to critically important inputs, including software and components. Thus, the Chinese government is pushing a strategy known as “dual circulation” that is meant to stimulate the development of domestic technology capabilities. This is seen as a big opportunity for many Chinese companies that hope to participate in the further development of a vertically integrated technology sector for China. Political and business leaders see this as an opportunity to push China to the next level. It is, however, not clear if this shift will enable Chinese technology companies to remain globally competitive if they lack access to foreign technology and research. Rather, it appears that the focus of vertical integration is to be able to serve the massive domestic market should the technology war with the US escalate. Even if Chinese companies can compete globally, this situation could result in two global technology systems that are not necessarily compatible. In recent years, there was a high degree of symbiosis between US and Chinese technology companies. If this link is broken, it could result in a slowdown of the process of innovation. It is reported that Chinese scientists and engineers are worried that a lack of access to Western technology will hold them back, similar to what happened to Soviet scientists during the Cold War.
The issue of technology decoupling has emerged because the United States has sought to limit the ability of Chinese technology companies to participate in the US market. Moreover, it has sought to limit the ability of Chinese companies to gain access to US technology. The Chinese authorities are reported to be considering a so-called nuclear option to deal with this. That is, they are considering restricting US access to Chinese-made pharmaceuticals. US imports of pharma products from China are substantial, with US-based pharma companies having engaged in massive offshoring to China over the past two decades. China is the world’s largest maker of active pharmaceutical ingredients. If it were to restrict such exports to the United States, it could be hugely disruptive to the US health care industry. The idea is that this would only be done if the United States does something to hugely disrupt China’s technology industry.
Meanwhile, both President Trump and his opponent Joe Biden have talked about reducing US dependence on China’s pharma industry, although accomplishing this would likely take a long time. If China undertakes the “nuclear option,” it could spur the United States to take strong steps meant to develop pharmaceutical independence, and it could lead the United States to engage in retaliatory action on other fronts. Thus, there is potential for an even more disruptive trade conflict between the two countries, one in which there might not be any winners. Meanwhile, a lot of pharmaceutical imports to the United States come from India, which relies heavily on China for inputs. If China pulled the plug on supplying India (in order to hurt the United States), there would be a negative impact on India’s large pharmaceutical industry as well.
The value of the US dollar has fallen sharply since the start of the pandemic. Why is this and what are the likely consequences?
First, let’s consider what fuels movements in currency values. All other things being equal, a currency will fall if the country’s interest rates decline relative to those of other countries. That is because lower rates make the currency a less attractive vehicle for holding assets and generating income. In the case of the Unites States, the exceptionally easy monetary policy of the Unites States likely contributed to the drop in the value of the dollar because it implies a prolonged period of exceptionally low borrowing costs. In addition, a currency will fall if a country’s inflation rate is expected to be higher than that of other countries. That is because inflation erodes the value of assets. Again, in the case of the United States, the easy policy by the Fed implies higher future inflation rates. In addition, a currency will generally decline if economic growth is expected to be weaker than in other countries. This is because slower economic growth implies a lower return on assets such as equities. Lower growth also hurts overall investor confidence. In the case of the United States, most economists expect weaker economic growth in the coming year than in Europe, in large part because of the failure to fully suppress the virus. Finally, a currency will often decline in value if investors expect the country to have an unsustainable external deficit. That is, investors expect that a large net deficit will require stronger exports and weaker imports in order to revert to a sustainable level. In the case of the United States, the fraught trading relations with its principal trading partners bodes poorly for a boost to exports. Investor uncertainty about the future of US trading relations has likely suppressed the dollar.
What has been, or will be, the impact of a weaker US dollar? For the trading partners of the United States, a weaker dollar implies a stronger domestic currency. This will be disinflationary, providing central banks more wiggle room to ease monetary policy without generating more inflation. In addition, a stronger currency will mean less competitive exports and more impetus to import goods and services. A stronger currency will mean that overseas assets will be cheaper, possibly generating more outbound investment. A stronger currency also means that commodities priced in dollars, such as oil, will be cheaper. Finally, a stronger euro could boost the global trading role of the euro, thereby hurting the dominant role of the dollar. For the United States, the cheaper dollar will mean stronger exports, weaker import growth, somewhat higher inflation (which is a stated goal of the Federal Reserve), and more inbound investment.
Interestingly, the US dollar has fallen principally against the currencies of other developed countries, such as Japan, the Eurozone, and the United Kingdom. Against major emerging economies, the dollar has increased in value. These include Brazil, Mexico, India, and Russia. Thus, these countries have not benefitted from a falling dollar.
Although the coronavirus was, by far, the biggest event of this year, the result of the US presidential election in November is likely to have a significant impact on the global economy, business environment, and geopolitics in general. The world view of the two candidates could hardly be more different. President Trump espouses a policy of “America First.” Recall that this phrase was the basis of a movement in 1940 to keep the US out of World War Two. The adherents believed that the United States, buffered by two oceans, had no business being involved in the outside world. It opposed alliances, especially those involving military action, and supported restrictions on trade and immigration. This world view ended with the war and a more globalist view informed US policy for the last 75 years, supported by both major parties. Trump has turned the table, endorsing restrictions on trade and immigration, dismissing alliances and treaties, and focusing on a mostly domestic agenda. Biden, in contrast, spent half a century in politics supporting the post-war bipartisan consensus. If Trump is reelected, he will likely continue to see trade as a zero-sum game, will restrict investment from China, will dismiss alliances such as the North Atlantic Treaty Organization and organizations such as the World Trade Organization, and will continue to restrict immigration. This implies more isolation and protectionism for the United States and, potentially, a vacuum in geopolitics that could be filled by other powers, such as China.
If Biden is elected, it is likely that the United States will, in part, return to the old consensus. This will mean a renewal of the Atlantic alliance and a bias toward freer trade, migration, and cross-border investment. It will also likely mean a return of the United States to the World Health Organization, the Trans-Pacific Partnership, the Paris Accords, and the Iran nuclear deal. However, on trade Biden will face obstacles and will have to navigate differences within his own party. In a recent interview, Biden was asked about Trump’s tariffs on China. He replied that he would “re-evaluate the tariffs upon taking office.” His staff then attempted to clarify his statement, evidently fearful that he would not be seen as sufficiently tough on China. Being hard on China is currently popular in the United States, because of both a perception that China’s trade policy has hurt the United States and concerns about human rights issues. Moreover, within the Democratic Party, there is a strong protectionist sentiment among many, especially in the labor union movement as well as among the far left who see freer trade as mainly benefitting big business. Thus, Biden, who’s instinct is likely globalist based on his Senate experience, must avoid being seen as too globalist within his party.
This situation is quite different from the past. Over the past half century, almost every US president was inclined toward freer trade and stronger alliances. Often, they or their parties faced opponents who complained that these policies were damaging to the country. Yet those opponents, upon taking office, usually reverted to globalist policies. For example, Bill Clinton ran against the first President Bush on a relatively protectionist platform, only to push for freer trade once in office. Likewise, Barack Obama ran in 2008 complaining that the second President Bush was too inclined toward free trade, only to push for more free trade himself. This time, a Democrat is running against a decidedly, and historically anomalous, protectionist Republican. He faces an electorate that, according to polls, is strongly suspicious of China but is still supportive of the benefits of trade. Navigating this will be tricky not only during the campaign, but even after becoming president should he win.
Industrial production bounced back strongly in July, rising 8.0% from June, the highest rate of monthly growth on record. Still, output remained 16.1% below a year earlier. The strong monthly increase was driven in large part by the automotive sector that saw output rise 38.5% from June. Other areas of manufacturing were up 9.0%. Clearly, the industrial side of Japan’s economy is recovering, but still has a long way to go to catch up to the pre-crisis level. Meanwhile, retail sales fell 3.3% from June to July after having increased strongly in the previous month. July sales were 2.8% below the level from a year earlier. The monthly decline varied by sector, with sales down 5.2% for general merchandise stores, down 20.9% for apparel stores, and down 2.6% for food and beverage stores. Nonetheless, sales were up 7.8% for motor vehicles.
The overall weakness of retail spending suggests that Japan’s consumer sector is failing to recover, boding poorly for overall economic growth in the current quarter. This follows a very sharp decline in GDP in the previous quarter. An index of consumer confidence fell slightly in August and remains well below the pre-crisis level. Evidently, the consumer economy in Japan is stalling. With Prime Minister Abe retiring, the new prime minister will likely have to focus on stimulating domestic demand.
Retail sales in the Eurozone started to falter in July after having grown in each of the last three months. The European Union (EU) reports that, in July, real (inflation-adjusted) retail sales fell 1.3% from June after having risen 5.3% in the previous month. In addition, real retail sales were up 0.4% from a year earlier. The good news is that the volume of retail spending has returned to the level prior to the crisis. The bad news is that spending stopped growing in the summer. The monthly decline was most pronounced in three categories: clothing stores (down 10.6%), internet shopping (down 7.7%), and computer equipment (down 6.7%). Only a strong increase in spending on automotive fuel prevented a much sharper monthly decline in spending. Real retail sales fell in Germany but increased in Spain and France.
Looking at the change in spending over the past year, it is possible to discern significant trends. For example, real internet spending in July was up 16.0% from a year earlier while real spending at clothing stores fell 25.8% from a year earlier. Thus, it is evident that European shoppers have made a sharp turn toward remote shopping, a trend that was already under way prior to the crisis and has accelerated during the crisis. Also, from a year earlier, spending is up in Germany, the Netherlands, and France but down in Spain, Portugal, and Greece. Thus, it appears that retail spending in northern Europe has recovered more quickly than in southern Europe. This could reflect the fact that the southern European countries suffered more draconian lockdowns early in the crisis. Thus, they have farther to go in order to return to normalcy.
Regarding Spain, it is currently experiencing a surge in the virus which, according to high-frequency data, is suppressing mobility. Thus, it seems likely that retail sales will not have grown in August. Thus, Spain may be hard pressed to have retail sales return to pre-crisis levels. The same could be true of other countries that experience a surge in the virus. The only other European country that is currently seeing a significant surge is France. Another factor that could stymie spending in the months ahead is the expiration of government-funded furlough subsidies for employers. Expiration could lead to a significant increase in unemployment and a decline in personal income.
In the Eurozone, inflation turned to deflation in August as energy prices continued to fall sharply. Specifically, consumer prices were down 0.2% in August versus a year earlier. When volatile food and energy prices are excluded, core prices were up 0.4% from a year earlier, the lowest level of underlying inflation on record. This means that the weakness of the economy is overwhelming the impact of a large increase in the money supply. Personal and business savings have increased, suppressing demand. Moreover, even though reported unemployment remains low, the reality is that many people are not actually working but are being supported by government furlough schemes that are about to expire. Hence, the decision to save heavily makes sense. Meanwhile, the European Union reports that the reported unemployment rate in the Eurozone is increasing rapidly, hitting 7.9% in July. This is the highest rate since late 2018. This means that, despite the various furlough schemes that have provided income to temporarily dismissed workers, many employers are permanently eliminating positions. In some cases, this reflects business failures. When furlough schemes do expire, the unemployment rate could increase quickly. In any event, the weakening of the job market and the weakness of demand have both contributed to historically low inflation.
The US government released the latest data on job growth for August. The report was surprisingly good, with relatively strong job growth and a sharp decline in the unemployment rate. The reason it was a surprise was that, with the expiration of enhanced unemployment insurance at the end of July, there had been an expectation that personal income would decline in August, leading to a decline in spending and weakness in employment. However, job growth continued nonetheless, perhaps reflecting the lag between changes in demand and changes in hiring patterns. That said, job growth decelerated from the previous month, suggesting the possibility that the expiration of stimulus funding began to have an impact in August. The government releases two reports: one based on a survey of establishments; the other based on a survey of households. Let’s consider both.
The establishment survey indicated that there were 1.371 million new jobs created in August, down from 1.734 million new jobs in July and 4.791 million new jobs in June. Moreover, 238,000 new jobs were temporary Census Bureau jobs that will disappear next month. Without those jobs, there were 1.133 million new jobs created in August. Meanwhile, the total level of employment was 316,000 above a year earlier; a small increase and not enough to compensate for population growth. Still, it is notable.
The increase in employment for the month included 249,000 jobs in retailing, 197,000 jobs in professional and business services of which 107,000 were in temporary services, 75,000 in healthcare, and 134,000 jobs in restaurants and bars. The latter figure was down from 525,000 in the previous month. Thus, job growth in a key consumer-facing industry decelerated sharply in August and overall employment in the industry remained 192,000 jobs below the level from a year earlier.
The separate survey of households found that a large number of people returned to the labor force, which means that they chose to work or look for work. Thus, the share of the adult population participating in the labor force increased from July to August. And many of the new participants found work, thereby pushing the unemployment rate down from 10.2% in July to 8.4% in August, the lowest level since the crisis began—but far above the pre-crisis level of 3.5% in February. Moreover, the number of people out of work for a short time fell sharply. This meant that many people who were dismissed early in the crisis returned to work. However, many large companies have lately announced significant permanent elimination of jobs. This has been especially true of the airline industry. Moreover, although participation increased in August, it remained far below the level from a year earlier. Specifically, the size of the labor force declined from 163.9 million people in August 2019 to 160.8 million in August 2020. The participation rate fell from 63.2% of the working age population a year ago to 61.7% today. Meanwhile, the number of working-age people not in the labor force increased from 95.5 million a year ago to 99.7 million now. Thus, despite the improvement in August, there is a long way to go.
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