What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Last week China published several economic indicators for October, and the data show that China’s economy continued to decelerate. Not only did the industrial side of the economy show considerable stress, but the retail sector also decelerated and automotive sales continued to decline. Here are the details.
The weakness of China’s economy has led the government to predict that growth in 2020 will be less than 6.0 percent. Premier Li Keqiang said, “The current external environment [has become] more complex and severe, with increasing downward pressure on the domestic economy, rapidly rising prices of pork and other products, and increasing difficulties in the business operations of companies.”9 The weak numbers might spur the government to boost fiscal stimulus measures. Although the government has taken steps to boost spending on infrastructure, it also reports that, in the first 10 months of the year, infrastructure investment grew slowly. Consequently, the government announced last week that it will lower the capital ratio required for infrastructure investment loans.10
The Eurozone economy continued to grow at a slow pace in the third quarter.11 Real GDP was up 1.2 percent from a year earlier, the same as in the first quarter and slightly lower than in the second quarter. These rates of growth were the lowest since 2014 when the Eurozone was in recession due to the debt crisis. By country, real GDP grew 0.5 percent in Germany, 1.3 percent in France, 0.3 percent in Italy, and 2.0 percent in Spain. Growth in Belgium and the Netherlands was strong. Outside of the Eurozone, the best growth in the EU took place in Central European countries such as Poland.
Germany’s feeble growth, which was slightly better than in the second quarter, was the second-worst performance since 2013. Many investors were relieved, however, that Germany just avoided a recession with real GDP up 0.1 percent from the previous quarter after having declined in the prior quarter. The economy continued to exhibit a bifurcation. On the one hand, the labor market is tight with very low unemployment and consumer spending continues to grow steadily. On the other hand, the industrial sector is in a recession, with manufacturing output declining. This is largely a consequence of trade uncertainty with respect to the United States and the United Kingdom. The fact that Germany avoided a technical recession likely reduces pressure on the government to implement a fiscal stimulus, which it has been reluctant to do. Indeed, German Finance Minister Olaf Scholz said that Germany is not in a crisis and that “we are cautiously optimistic. We will have bigger growth next year.”12
The US economy is laden with contradictions. Last Friday, equity prices reached new highs at the same time that the government released data indicating that, in October, industrial production continued to decline and retail sales increased only modestly. So why did equity prices continue to rise? The reason given by commentators is that White House economic advisor Lawrence Kudlow said that a US-China trade deal is near.13 In addition, investors were evidently excited that retail sales increased after having decreased in the previous month. Let’s examine the details.
Federal Reserve Chairman Powell said that he sees no reason to cut interest rates again in December.18 Moreover, he expects to leave policy unchanged “as long as incoming information about the economy remains broadly consistent with our outlook.” The Fed has cut the benchmark rate by 75 basis points this year but signaled in October that it will pause monetary policy changes going forward. Powell indicated that rates had been cut because of low inflation and headwinds stemming from trade wars. Markets were not surprised by Powell’s comments and equity prices and bond yields were relatively steady following his remarks. In Congressional testimony, Powell was asked about the possibility of negative rates in the United States. He said this is unlikely and inappropriate for an economy with relatively significant inflation and strong growth—unlike in Europe and Japan. Finally, Powell warned that the US government runs an unsustainably large budget deficit. He said this is worrisome if the economy should head into a recession. The deficit could stymie the willingness or ability of the Congress to engage in fiscal stimulus, which would likely be needed in the event of recession.
In the United States, inflation accelerated in October as energy prices spiked. The consumer price index was up 0.4 percent from September to October, the biggest increase since March 2019.19 Prices were up 1.8 percent from a year earlier, roughly in line with the experience of the past few months. When volatile food and energy prices are excluded, core prices were up 0.2 percent for the month and up 2.3 percent from a year earlier. This was lower than the 2.4 percent recorded in September, but higher than what has been seen in the past year. Underlying inflation has been consistently above the Fed’s 2.0 percent target for the past year. The Fed, however, chose to cut interest rates because of concerns about threats to growth. Still, with inflation relatively steady, the Fed’s decision to pause further cuts to interest rates appears sensible.
Meanwhile, wages continue to rise, but real (inflation-adjusted) wages are not moving rapidly. In October, real average hourly earnings were actually down 0.2 percent from the previous month and up only 1.2 percent from a year earlier.20 Thus, despite an unusually tight labor market, wages are still not responding in a way that would significantly boost consumer purchasing power or lead to accelerating inflation. Rather, it seems that previously discouraged workers continue to flood into the labor force due to low unemployment and robust job opportunities. This increase in the supply of labor has helped to suppress wage gains. Also, with higher tariffs now working their way through the pipeline and thereby set to boost prices of some consumer goods, we could see a deceleration in real income in the coming year. The consumer sector has helped to offset weakness in investment and exports, thereby enabling the economy to grow at a modest pace. If consumer spending weakens, however, growth could falter.
The impact of US tariffs on imports from China is starting to show up in the data. It is reported that the number of trans-Pacific freight containers entering the ports of Los Angeles and Long Beach, which is the largest port facility in the US, fell 14.1 percent in October versus a year earlier.21 These two ports handle 37 percent of all freight containers entering the United States. The decline is likely due to tariffs, which increased earlier this year and were applied to more consumer goods earlier this year. There are anecdotal reports that US retailers have scaled back their orders for imported consumer goods as a result of the tariffs. Instead, retailers are trying to maintain prices by working down existing inventories that were previously boosted in anticipation of tariffs. Ultimately, however, US consumers will likely face higher prices. This will reduce consumer spending power and have a negative impact on the volume of consumer purchases. Until now, consumer spending has been relatively steady, helping to offset the negative impact of weak investment and exports.
Going forward, the impact of US tariffs on US consumers will depend on several factors. These include the degree to which retailers pass their higher costs onto consumers, the degree to which consumer demand is sensitive to price increases, and the degree to which producers shift production from China to Vietnam and other countries. It is reported that, while imports from China are down sharply, imports from Vietnam are up sharply. Finally, while investors were optimistic in the past two weeks that the US would soon start to scale back tariffs, the current zeitgeist suggests otherwise. The latest comments coming from the US administration indicate that a trade deal, including tariff reductions, is not imminent. Moreover, the US remains officially committed to boosting tariffs in December and continues to contemplate new tariffs on imported automobiles.
Early last week it appeared that the likelihood of a phase one US–China trade deal was diminishing, in part because China was insisting that the United States reverse the tariff increases that have taken place during the trade war—a demand that the United States seemed unlikely to meet. Moreover, a Chinese government affiliated social media site reported that the Chinese side is demanding that the US remove all tariffs imposed in the past two years as a precondition for the first phase deal that is being negotiated.22 It was also reported that Chinese officials are concerned that, having made considerable concessions to the United States, China is not getting sufficient US concessions in exchange. Thus, they are keen to see a significant, albeit phased, decline in US tariffs.
Initially it appeared that the United States only agreed not to increase tariffs. Later in the week, however, it appeared that a deal was more likely,23 largely due to a statement from a Chinese official who said that a deal was in the works that involved a phased rollback of US tariffs and not just a halt to tariff increases. Some US officials concurred that this was under consideration. Although investors were pleased by this comment and drove up equity prices, the official was quick to note that the deal is not finished and that more work needs to be done. The official also said that “as for how much will be eliminated in the first phase, that will depend on the content of the phase one agreement.” Officials in Washington started to talk about where the two presidents would meet to sign the trade deal.
However, by the end of last week, President Trump said that there are no plans to reduce tariffs. It is not even clear if the United States will agree to cancel the new tariffs scheduled for December. Trump said that he has “not agreed to anything.” In addition, he said that “China would like somewhat of a rollback, not a complete rollback, because they know I won’t do it. Frankly they want to make a deal a lot more than I do.”24 However, he continued to speculate on where the deal will be signed. Trump’s remarks came after his trade advisor Peter Navarro attempted to stifle investor expectations that tariffs will be cut. Navarro’s comments revealed a persistent division among Trump’s advisors. Trump’s own comments suggest that he might be veering closer to the hardline advisors like Navarro rather than his Treasury Secretary Steve Mnuchin. Still, it is hard to know. Thus, once again, observers are left guessing what will happen and having to deal with persistent uncertainty. The reality is that, at the end of the day, the decision about tariffs will be made by the president of the United States, and he has a history of keeping his cards close to his vest and periodically changing his mind about which cards to play.
Equity prices were mostly up last week when investors were confident that a deal was imminent. Trade optimism and/or pessimism has been driving equity market trends in recent weeks. One effect of the recent market optimism has been that the US yield spread (the gap between the yield on the 10-year Treasury bond and the three-month Treasury bill) is no longer inverted and has remained positive for several weeks. An inverted yield spread is often a good predictor of recession, even after the inversion ends. Why did the inversion end? Because the Fed cut the benchmark interest rate recently, leading to a decline in short-term rates. In addition, the yield on the 10-year bond has risen, currently at 1.9 percent versus 1.5 percent in early October,25 reflecting rising optimism about growth and inflation. Still, the bond yield remains relatively low compared to the past year. It was above 2.5 percent as recently as May. Moreover, the so-called breakeven rate, which is a market forecast of 10-year inflation, remains close to the lowest level since late 2016.26 Despite the strongest labor market in half a century, US wages are not rising sufficiently to cause an acceleration in inflation. That likely reflects continued inflows of formerly discouraged workers into the labor force. Thus investors are evidently not confident that inflation will soon accelerate further. Even though they are pleased that a trade deal might be imminent, they still expect modest growth and, therefore, low inflation.
The nature of any trade deal, should it happen, will determine whether investors grow significantly more confident. What investors crave is stability and a degree of certainty about future policy. Even if there is an initial trade agreement between the United States and China, it will not likely have a big positive impact if it is not seen as credible and enduring. Moreover, given the fraught relationship between the United States and the European Union, even a cross-Pacific deal will not likely suppress investor jitters.
When the United States withdrew from the Trans-Pacific Partnership (TPP) at the start of the Trump Administration, the Chinese government was pleased. This was because China was excluded from the TPP which it saw as a vehicle for the United States to boost its geopolitical footprint in the Asia-Pacific region. Moreover, it saw the United State’s withdrawal as an opportunity for it to lead the process of trade liberalization in Asia. Specifically, it hoped to implement a regional agreement called the Regional Comprehensive Economic Partnership (RCEP) that, like the TPP, would liberalize trade in the region and would be led by China. However, the RCEP was also meant to include fewer rules and restrictions than the TPP. Most importantly, it would not include the United States. Also, the RCEP will include seven of the 11 countries that originally agreed to the TPP. Meanwhile, the non-US members of the TPP have reconstituted that agreement as a way to offset the rising power of China.
Now, after years of negotiations, it appears that the RCEP is close to being finalized. Moreover, it will include most of the countries of East Asia including the 10 countries of ASEAN as well as South Korea, Japan, China, and a few others. It was originally intended to include India, yet India announced last week that it will not participate in the RCEP because the deal fails to include protections against import surges. The 16 countries that have negotiated the RCEP issued a statement saying that all the countries other than India “have concluded text-based negotiations for all 20 chapters and essentially all their market access issues.”27 India is a relatively protectionist economy and was resistant to substantial trade liberalization with China from the start. Proponents of the RCEP saw Indian participation as likely to signal a different direction on the part of the world’s second most populous nation. The 15 members of the RCEP said that India is still welcome and expressed hope that its issues can be resolved.
In any event, it appears that the RCEP involves combining various already existing bilateral trade agreements in the region and implementing common rules of origin. Its importance stems, in part, from the fact that it would encompass 2.5 billion people and more than a quarter of global GDP. As such, it would be the largest free trade area in the world. Still, it is just a free trade area rather than an economic community. It does not include the provisions on environment, labor markets, subsidies, and rules regarding state-owned companies that were hallmarks of the TPP.28 From China’s perspective, the RCEP is a platform that marginally boosts its influence in the region, but not nearly as much as the heavily touted Belt & Road Initiative (BRI). The latter involves substantial Chinese investment, through government-controlled entities, in other regional economies. It enables China to gain better access to resources, shift production of low value-added goods to other countries, and increase political influence in other countries. However, when the RCEP and the BRI are combined, it is clear that China is rapidly boosting its leadership role in the global economy.
As noted above, India will not be included in the new regional trade agreement led by China. Rumki Majumdar, an economist with Deloitte India, offers her perspective on what happened:
One of the criticisms of the eurozone architecture is that, although it involves monetary union, it does not include financial integration. Unlike the United States, there is not a unionwide system of bank deposit insurance. Rather, this type of government service is provided at the national level, putting individual governments at risk given that they lack control over monetary policy tools. One of the obstacles to moving in the direction of financial integration has been resistance on the part of Germany. That largely reflects German suspicion that any financial union will effectively mean that Germany is most liable for any bank difficulties within the broader union. After all, during the last crisis, it was mostly non-German banks that ran into trouble. Yet absent a banking union, economic difficulties in the eurozone could once again lead to stress on banks that national governments are not equipped to handle. The result is that monetary policy implemented by the European Central Bank (ECB) might not be effective because the channels for transmitting policy to the finance sector do not work effectively.
Now, it appears, Germany is having a change of opinion on this issue. In an article in the Financial Times, Germany’s Finance Minister Olaf Scholz endorsed financial integration, including eurozonewide deposit insurance.29 He also proposed that the eurozone implement a common corporate tax structure in order to prevent companies from making resource allocation decisions on the basis of tax considerations. Financial integration within the eurozone has long been urged by the IMF, the ECB, EU leaders, France, and many leaders in the financial services community. However, German political leaders have mostly been resistant. Although Scholz comes from the Social Democratic Party that is in coalition with Chancellor Merkel’s CDU/CSU, his strong support for integration likely carries some weight.
France’s labor market reforms appear to be bearing fruit. Temporary work stopped growing after the reforms were implemented two years ago while permanent employment growth accelerated. The government reports that, in the third quarter, employment was up 0.3 percent from the previous quarter.30 The reforms were meant to make temporary hiring more expensive while, through changes in taxation and regulation, encouraging more full-time hiring. Meanwhile, industrial production continues to grow even as neighboring Germany suffers a sharp decline. In part, France could be benefitting from less exposure to the global economy than Germany. In addition, France is more dependent on the production of consumers goods while Germany is more dependent on the production of capital goods.
Given the global slowdown in investment, Germany has been especially hard hit while France benefits from continued growth of consumer spending in Europe and the United States. However, despite recent troubles in Germany’s economy, German exports rebounded in September,31 driven by rising exports to the eurozone, United Kingdom, and United States, thus offsetting declining trade with China. This might have helped Germany avoid a technical recession in the third quarter.
Mexico continues to suffer from a decline in business investment. Gross fixed investment fell 4.6 percent in August versus a year earlier, the seventh consecutive month of decline.32 It has fallen in 10 of the last 12 months. The main problem is the export-oriented industrial sector. Investment in machinery and equipment fell 9.5 percent while investment in the construction sector was up 0.1 percent and investment in the residential sector was up 3.4 percent. In part, the problem of investment reflects problems in the large automotive sector. Mexican exports of automobiles fell 19.5 percent in October versus a year earlier. In the first 10 months of the year, automotive exports were down 1.7 percent. The weakness reflects weak demand in the United States. In addition, weak investment reflects two other factors. One is the failure of the US Congress to approve the renegotiated trade deal between the United States, Mexico, and Canada. This has created persistent uncertainty. Second, investors are concerned about the policies of the government that came into power nearly a year ago. The IMF has criticized the administration for failing to address the problem of Pemex’s debt and not allowing further private sector investment in the large energy sector.33 Finally, weak investment is contributing to feeble economic growth. The government reported weak economic growth in the third quarter.
The Eurozone economy continues to decelerate. The European Union (EU) reports that, in the third quarter of 2019, real GDP was up 0.2 percent from the previous quarter and up 1.1 percent from a year earlier.39 The last time that quarterly growth was slower than 0.2 percent was in early 2013. In addition, the annual figure in the third quarter was the lowest since 2014. Growth varied across Europe, with annual growth of 2.0 percent in Spain and only 0.3 percent in Italy.
With the Eurozone economy growing slowly, it is not surprising that unemployment has been steady. In September, the unemployment rate was 7.5 percent, the same as in August as well as in June.40 It is down from 8.0 percent a year ago. The number of unemployed workers in the Eurozone has not changed significantly in the last three months. The lowest unemployment rates in the Eurozone were in Germany (3.1 percent) and the Netherlands (3.5 percent). The highest rates were in Greece (16.9 percent), Spain (14.2 percent), Italy (9.9 percent), and France (8.4 percent). Although Germany currently has one of the weakest economies in the Eurozone in terms of growth, it nevertheless has a very tight labor market and relatively high inflation compared to other countries. Thus, there appears to be a geographic bifurcation of Europe that is influencing attitudes toward policy. Germany’s representatives on the European Central Bank (ECB) tend to resist the easy monetary policies that are more popular in Southern Europe.
Meanwhile, inflation in the Eurozone remains muted.41 In October, prices were up 0.7 percent from a year earlier, the lowest inflation since November 2016. The low level of inflation, in part, reflected the impact of declining energy prices which were down 3.2 percent from a year earlier. When volatile energy and food prices are excluded, core prices were up 1.1 percent in October versus a year earlier. This underlying rate of inflation remains well below the ECB’s target of 2.0 percent. A combination of persistent low inflation and weak growth explains the ECB decision to maintain an unusually easy monetary policy. Inflation varies by country within the Eurozone. In October, annual inflation was 0.9 percent in Germany and France, 0.2 percent in Spain and Italy, and –0.2 percent in Greece. It was 2.8 percent in the Netherlands.
When former Argentine President Cristina Fernandez de Kirchner left office four years ago, she was not popular. That was because inflation was high, government borrowing was unsustainable, and the economy was not growing. Four years later, inflation is high, debt is unsustainable, poverty is rising, and the economy is shrinking. And, Cristina Fernandez was just elected vice president. What happened? Four years ago, businessman Mauricio Macri was elected to succeed Fernandez on a pro-market platform that was the antithesis of Fernandez’s populist politics. Macri was expected to implement a wide range of market-opening reforms meant to stabilize Argentina’s long troubled economy. Instead, he quickly faced a series of crises stemming from a general flight of capital out of emerging markets and toward the United States at a time of rising US borrowing costs. Macri was forced to raise interest rates and intervene in currency markets in order to stabilize a falling peso. This failed. He evidently could not convince investors that things would improve. He ultimately went to the International Monetary Fund (IMF) for a US$57 billion bailout. That, in turn, stabilized the situation but failed to generate an economic revival in time for Macri’s hoped for reelection.
In October, Macri lost his bid for reelection, although by a smaller margin than had been anticipated. Cristina Fernandez chose not to run for president because of her lingering unpopularity. Rather, she chose Alberto Fernandez (no relation) to head the Peronist ticket while she ran for vice president. Many expect her to be the true power behind the throne. While there is a lack of clarity on what the new team will do, we know that the Peronists traditionally tend to favor interventionist, statist policies. However, with a massive external debt and inflation now above 50 percent, the new government will have little flexibility. It will have to renegotiate debt while satisfying the terms of its IMF bailout. Investor worries that the government will demand a haircut from bondholders led to a rise in bond yields today. When Cristina Fernandez was in power during the first decade of this century, Argentine was able to circumvent capital market constraints by borrowing from Venezuela’s Hugo Chavez. That opportunity is now gone, so Argentina will be constrained if it wants to retain access to capital markets.42 For now, the only certainty is that the economy is shrinking and, with inflation high, the currency remains under pressure.
A side effect of the current trade war has been a substantial drop in cross-border direct investment, also known as foreign direct investment (FDI). According to data compiled by the OECD, the global volume of FDI fell 20 percent in the first half of 2019 versus the same period a year earlier.43 This decline accelerated in the second quarter when global FDI was down 42 percent from the same period a year earlier. In the first half of 2019, FDI into the US fell 25 percent from a year earlier and that into the European Union (EU) fell 62 percent, while FDI into China increased by 5 percent. Notably, FDI from China to the US fell more than 90 percent over the last three years. That decline comes as higher tariffs have caused bilateral trade between the United States and China to decline by about 10 percent in the past year. Not only has the US-China trade dispute had a negative impact on global cross-border investment. Brexit uncertainty has played a role as well. The OECD reports that FDI into the United Kingdom fell by more than 50 percent in the first half of 2019 versus a year earlier. This follows a decline of 33 percent in the previous year. Evidently companies that previously looked to the United Kingdom as a gateway to Europe are looking elsewhere. While the overall decline in global flows of FDI likely results from trade restrictions and uncertainty, other factors likely played a role. These include investor pessimism about the state of the global economy, the evident slowdown in global growth, and the possibility of a recession in the next year.
For some time, the US administration has threatened to impose tariffs on automotive imports from the EU, claiming that Europe’s bilateral trade surplus with the United States in automotive trade is a reflection of unfair trade practices. This is not the case. The bilateral imbalance is not meaningful. However, it is true that the EU tariff on automotive imports from the United States is higher than the US tariff on cars. The United States, however, imposes a much higher tariff on sport utility vehicles, so both sides evidently have a grievance. In any event, earlier this year the United States agreed to delay tariffs on EU vehicles until November 13 while negotiations take place. It’s already November and the United States will soon have to decide whether it will follow through on its threat, especially as there has not been any reported progress in the negotiations. Among the options available to the US administration is imposing a 20 to 25 percent tariff, or perhaps a smaller tariff of 10 percent, on European vehicles and parts. The administration could decide to only target cars or only target parts. Finally, it could decide to postpone tariffs again—although doing so would likely create the impression that the administration is not serious in its negotiations and that its threats are not credible. Yet imposing any tariff would probably shake financial markets, ultimately hurt trade flows and investment, and invite retaliation by the EU. Thus, there are no good options for the United States. Moreover, the US administration has not signaled its intentions.