What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
During the Vietnam War, there was a Republican US Senator from Vermont, George Aiken, who offered a solution to the seemingly intractable problem of fighting an unwinnable war. He said that the United States should simply “declare victory and get out.”1 That might be the optimal solution to the current trade war between the United States and China. The damage done to both sides by the current and prospective tariffs is likely to be far greater than the contentious trade practices that led to the imposition of tariffs in the first place. Both sides would probably be better off if the trade war had never begun. Yet the Aiken solution is not likely to happen. Rather, it appears that tensions between the United States and China are getting worse and that the prospect for a resolution before tariffs go up in January are lessening.
At the Asia-Pacific Economic Cooperation (APEC) summit in Papua New Guinea, there was no communique for the first time in APEC’s 29-year history because the United States and China could not agree on a statement.2 US Vice President Pence (representing President Trump) and Chinese President Xi traded barbs. Pence said that the United States “will not change course until China changes its ways.” He added that “China has taken advantage of the US for many, many years and those days are over.” Xi said that “unilateralism and protectionism will not solve problems but add uncertainty to the economy.”3 He said that trade wars produce no winners. Meanwhile, it was reported that the failure to release a communique largely came down to disagreement over one sentence: “We agreed to fight protectionism including all unfair trade practices.”4 China is reported to have opposed this statement. It saw the sentence as singling out China. Aside from the United States, other Pacific Rim nations attending the conference agreed with the US complaints about some Chinese trade practices. These include forced technology transfers, subsidies for state-owned enterprises, and restrictions on foreign investment.5 In addition, the United States alone has complained about China’s trade surplus.
As for the G20 summit, the group’s communique has always included a statement expressing opposition to protectionist policies. Not necessarily this time. When the G20 leaders meet in Buenos Aires this week, the communique is not likely to include this provision, based on the draft currently in circulation.6 Instead, the communique will likely include statements lauding the importance of the multilateral trading system and supporting a “level playing field.” This follows tension at this year’s G7 summit in which the United States objected to the free trade aspirations of the other leaders, ultimately resulting in the United States rejecting the agreed upon communique.7 And, as stated, there was no communique released after last week’s APEC summit. To prevent that fate, negotiators have avoided the talk about protectionism. In addition, they have watered down8 other statements that previously had been considered uncontroversial boilerplate. These include statements on the importance of adherence to trading rules, the need to boost funding for the International Monetary Fund (IMF), and the need to address climate change.
Of course, the main focus of the upcoming summit is the expected discussion between US President Trump and Chinese President Xi. Many investors had hoped that the upcoming meeting would provide an opportunity for the two sides to ease tensions and reach an accord that would lead the United States to drop plans to boost tariffs in January.9 Recall that, in October, the United States imposed 10 percent tariffs on US$200 billion in Chinese imports, which are set to rise to 25 percent, if a new trade deal isn’t made. The United States had previously imposed a 25 percent tariff on US$50 billion of Chinese imports. In addition, President Trump has suggested that the United States might impose tariffs on all US$267 billion remaining imports from China.10
Global investors are holding their collective breath, hoping for a breakthrough that would release the tension and possibly lead to a surge in asset prices. The alternative is a failure to reach an agreement, a US decision to boost tariffs on China, and a likely further drop in asset prices. Some analysts believe that the most likely outcome will be an intermediate deal.11 That is, they don’t expect a breakthrough in which each side makes major concessions. Nor do they think talks will break down in acrimony. Rather, they believe both sides have an incentive to avoid a worsening trade war. As such, they expect the two sides to agree to continue talks while putting new trade restrictions on hold. This would likely give President Trump the opportunity to claim success. Recall that, when he announced the revised North American Free Trade Agreement, his approval ratings improved.12 This outcome is good for him politically, especially following the weak performance of his party in midterm elections. For President Xi, it is likely that the trade war is already having a negative economic impact on China. Therefore, the imperative is to avoid further harm.
Finally, there are indeed indications that the trade dispute is already having a negative impact on trade flows and, consequently, economic activity. The Organisation for Economic Co-operation and Development (OECD) reports that global container port traffic grew only 2.0 percent in the third quarter versus a year earlier,13 the slowest growth in two years, and a sizable deceleration from early 2017 when traffic was rising at a rate of nearly 8.0 percent.
There has been a near perfect storm of negative news leading to a sharp drop in global equity and oil prices.14 For many major US-based companies, the drop in prices has wiped out the gains seen in 2018. In addition, the most widely used measure of expectations of US inflation fell sharply. Here are some highlights.
The equity market rout, which has been underway for several weeks and continued last week, has been especially concentrated in the technology sector. The major technology companies have lately seen very substantial losses of market capitalization.15 Among the likely reasons are concerns about the impact of trade wars on supply chains, worries about how technology companies will deal with increasing concerns and potential regulations about privacy and data security, fears that a slowdown in global growth will hurt demand for technology products and services, and concerns that valuations were previously exhibiting the characteristics of a bubble. The expectation that interest rates will continue to rise could have been responsible for bursting a bubble. Moreover, the rise in interest rates and fears about the potential consequences of a trade war have likely contributed to equity price losses for non-technology companies as well.
Energy company shares fell sharply as oil prices tumbled.16 Brent crude was down substantially last week, and has fallen by more than a quarter in the past two months, as many traders have reevaluated the outlook for energy supply and demand. The sharp rise in US crude production has led many observers to speculate that supply will likely overshadow demand in the coming year, especially as the global economy appears to be decelerating. US President Trump has praised the Saudis, attributing the decline in prices to their decisions. Yet the Saudis are actually trying to buttress prices by cajoling other OPEC producers to cut production,17 without success – as yet.
Still, Trump’s positive comments about the Saudis, especially in light of the controversy surrounding the murder of a Saudi journalist, mean that the United States likely has increasing leverage with Saudi Arabia.18 That is, the Saudis face strong criticism at the moment, especially in the US Congress. Thus, with Trump seeming to shield them from potentially onerous sanctions, they are clearly indebted to him. Perhaps they will, consequently, be restrained in their efforts to boost prices. More likely, they will simply be unsuccessful, in which case prices are likely to fall further.
Meanwhile, yields on so-called “junk bonds” have risen sharply in recent days as lower oil prices and higher interest rates have caused concerns about the viability of high-yield corporate debt. The spread between high-yield and Treasury bonds has increased to its highest level since 2016.19 In addition, there is concern that, with higher yields across the board, credit rating agencies might shift some corporate bonds into junk status. If that happens, some institutional investors, such as pension funds and insurance companies, would have to sell such bonds, likely leading to a sharp rise in their yields and further losses for investors.
The best measure of expectations for future inflation is the so-called “breakeven” rate. This is the difference between the yield on the 10-year government bond and the yield on Treasury inflation protected securities. The latter guarantees that the principal on the bond moves in line with inflation. Thus, the yield is the after-inflation yield. The difference between the two yields is, therefore, the expectation of inflation over the next 10 years. Notably, the breakeven rate has now fallen below 2.0 percent for the first time since early January, having previously skirted the 2.2 percent level.20
This decline suggests that investors are rethinking the degree to which the US economy is facing bottlenecks due to strong demand. In addition, the rising value of the US dollar, by suppressing import prices, is also contributing to expectations of lower inflation. The Federal Reserve watches the breakeven rate and could choose to ease the pace of interest rate increases if it believes that inflation expectations are firmly anchored below the target rate of 2.0 percent.
There is a debate under way about the future of China’s private sector. There is general agreement that the huge growth of the private sector over the past 40 years has played the dominant role in boosting China’s living standards. Today, the private sector accounts for 60 percent of economic activity and 80 percent of employment.21 Yet, in recent years, the government appears to have shifted resources to the state sector. As recently as 2013, private businesses received about 60 percent of bank loans. By 2016, this figure had fallen to 22 percent.22 Thus, most bank lending, which is undertaken mostly by state-run banks, now goes to state-run companies.
Private enterprises must rely on either the non-bank shadow banking system or issuance of bonds and equities in order to raise capital. However, the government has lately cracked down on the shadow banking system owing to concerns regarding the excessive increase in non-transparent debt.23 In addition, volatility in equity markets over the past two years led to many private Chinese companies having trouble raising cash. Consequently, many were bought out by state-run companies in what has effectively been a nationalization of private business. It is reported that 32 companies listed on the Shanghai and Shenzhen exchanges have been acquired by either the central government or regional governments.24 The question now is to what extent the private sector will drive future economic growth. And, if the role of the state continues to rise, what impact will this have on the rate of economic growth and on the ability of China to generate innovations that boost productivity and global competitiveness.
The US administration is considering imposing restrictions on the export of advanced technologies.25 Specifically, it said that it wants to determine “whether there are certain emerging technologies that are essential to the national security of the United States.” The government is concerned that such technologies as artificial intelligence, genomics, microprocessors, quantum computing, flight control algorithms, and mind-machine interfaces, among others, could be used by foreign companies, especially in China, to boost their competitiveness. In addition, the United States worries that such technologies might help boost the military prowess of China. Some US companies see restrictions on exports of such technologies as needed to stem the alleged theft of intellectual property and to protect the competitiveness of US companies.
At the same time, some US-based technology companies worry that restrictions will likely hurt their competitiveness and their ability to manage global supply chains. Many technology companies operate facilities in both the United States and China, as well as in other East Asian countries, and rapidly move products and software across borders in order to operate the most efficient possible supply chains. If the US administration imposes restrictions, it could disrupt such processes. Moreover, restrictions might lead China to retaliate, especially against US-based technology companies.
There has lately been a sharp drop in the value of emerging market currencies,26 in part due to the tightening of monetary policy in the United States. Two emerging countries in particular, Turkey and Argentina, have gone through crises involving sharp depreciation followed by stunning increases in short-term interest rates. The crises stem, in part, from the fact that these countries have an onerous level of external debt. Other countries such as Brazil, India, and Indonesia have been compelled to keep interest rates higher than otherwise, lest their currencies fall sharply, creating problems in servicing foreign debts. Meanwhile, concern is growing among investors and analysts that many poor emerging markets are laden with debts that could become more onerous as currencies fall, commodity prices drop, and interest rates rise.
Of particular concern is the role played by China in boosting the debt of some emerging countries through its Belt and Road Initiative.27 This program is meant to enable China to assist friendly nations and skirt the conditionality requirements set by the World Bank. The IMF is nervous about this, especially given the lack of transparency in China’s lending program.28 China has provided large loans to emerging countries, without conditionality, often to assist countries that are politically aligned with China and/or are important sources of commodities for Chinese industry. The volume, terms, and timeframe of such lending have not been transparent, and the risk involved can only be estimated. Since the start of this century, China has loaned about US$143 billion to African countries, many of which are now seen as at-risk by the IMF.
Indeed, the IMF says that, in 2017, the share of countries eligible for IMF loans that are either in distress or at a high risk of distress was higher than at any time since the last global financial crisis. The IMF fears that China’s lending will likely render the IMF responsible for cleaning up the mess that could emerge in the near future. Moreover, the IMF is concerned that excessive debt could hinder the future development of these countries, reducing their access to capital and requiring a large share of national output to be diverted to debt repayment. China initiated the Belt and Road program after its goal of achieving greater financial influence at the IMF was rebuffed by the US Congress.
As expected, the United Kingdom and the European Union (EU) have agreed on the text of an exit agreement. Prime Minister May successfully persuaded her cabinet secretaries to support the deal. However, after that, things started to fall apart. Several ministers have already resigned in protest against the deal,29 boding poorly not only for getting the deal through Parliament, but also for the sustainability of the current government. Brexit supporters are rallying in opposition to the deal. Some have begun the process meant to cause a vote of no confidence. If such a vote were to succeed among Tory Members of Parliaments (MPs), then the next step would be the selection of a new Tory leader who would become prime minister. Even if a no-confidence vote fails, as of this writing it appears unlikely that the prime minister’s deal will pass the Parliament—although that could change. If it fails, there would probably be a motion of no confidence. In addition, failure to pass the deal in Parliament would likely lead to either a new election, another referendum, or both. Yet there is little time for a new referendum before the United Kingdom actually exits the EU in March 2019.
The deadline to leave could be extended by the EU if requested by the United Kingdom, but it would require unanimity among the other 27 members. Some in Parliament have called for another round of negotiations with the EU. However, this seems unlikely. German Chancellor Merkel said, “For me, the question of further negotiations does not arise at all. The worst case and the least regulated case would happen if there was no deal at all.”30 Other European leaders also expressed strong reservations about negotiations.
Meanwhile, the deal on the table would effectively render the United Kingdom a member of the single market, having to abide by EU rules, for an extended period of time,31 until a new trade agreement between the United Kingdom and the EU can be reached. The latter could take a decade to complete. Meanwhile, the deal would mean that EU courts would still hold authority, although British representation in such courts would disappear. In addition, there would be a permanent “backstop” meant to prevent a new border between Ireland and Northern Ireland. It would mean that Northern Ireland would be permanently subject to EU rules. Britain would not be able to negotiate trade deals with other countries during this period. Nor would it have any say in EU deliberations.
Supporters of Brexit note that the proposed deal effectively makes Britain a member of the EU without any say in its affairs. Those who prefer to remain in the EU say essentially the same thing, but from a differing perspective. Few seem to find much merit in this deal. What might save it, however, is the idea that the alternative could be even worse. The alternative to the deal is the much-feared “hard Brexit,” in which case Britain leaves with no deal in place. Tariffs would rise and the regulatory environment would be highly uncertain, and likely costlier. That is why many business leaders and groups favor the deal,32 warts and all. At the least, it would provide them with a roadmap and avert a dramatic change in the rules of the game.
When, earlier this year, the United States imposed a 25 percent tariff on US$50 billion in imports from China, it allowed US companies to seek exclusions from the tariffs if the tariffs would cause damage to their competitiveness. The result was that there were over 10,000 requests for exclusions. About 800 requests have been denied and almost 400 have been approved. The remainder are in the review process.33 Meanwhile, the United States subsequently imposed a 10 percent tariff on US$200 billion in imports from China, which went into effect in late-September and are set to rise to a 25 percent tariff in January if a new trade agreement is not reached.34 Yet the US government did not offer companies an opportunity to seek exclusions from these tariffs. However, the administration did offer subsidies to farmers who have been adversely affected by the retaliatory tariffs imposed by China.35 Indeed, China has imposed tariffs on US$110 billion in imports from the United States in retaliation. Moreover, given that most imports of US goods into China now face higher tariffs, it is likely that further retaliation will take the form of non-tariff barriers, such as limiting the ability of US companies to do business in China.
The irony in all of this is that the US administration is strongly committed to deregulation in order to reduce the cost of regulatory compliance and to allow companies to have greater flexibility in managing their assets. Yet the tariffs and exclusions could be viewed as a form of regulation that is already imposing a cost on companies. Finally, while the economic consequences of the trade policy are largely negative, the political consequences are a bit more nuanced.
Fighting China’s alleged misbehavior is popular in the United States, and is not likely to be resisted by the incoming Democratic majority in the House. Indeed, many Democratic members of Congress lean toward protectionist sentiment. Republicans, however, are in a quandary. Traditionally, they are free traders who are not happy about tariffs. Yet many are reluctant to challenge a popular policy from a president of their own party. Thus, it is likely that the trade war with China will continue.
Economic data from China point to a further deceleration in economic activity. First, data on credit growth indicate that banks are not responding to government’s effort to boost credit. It is reported that, in October, new bank lending declined by half from September.36 Moreover, total social financing, which is a broader measure of credit creation that includes all forms of bank and non-bank lending, declined by two-thirds from September to October. The volume of such funding hit the lowest level since recordkeeping began in January 2017.
All of this suggests that monetary policy is not having the desired effect. The central bank has cut the reserve ratio of banks, with the goal of stimulating more lending. Yet other factors are evidently discouraging new lending. For example, there is evidence of a further downturn in activity in the critically important property market. It is reported that sales of new homes, when measured by area, fell 1.3 percent in October versus a year earlier.37 Overall sales of property were down 3.1 percent in October versus a year earlier, also measured in area. This follows a decline in the previous month as well. Given that prices continued to rise, however, the value of sales was up over the previous year. In addition, new construction starts were up, but at a slower pace than in recent months. Finally, land transactions were down 22 percent from a year earlier.38 All of this confirms that the property market is weakening, which at least partly explains the weakness in credit creation. Given the outsized role of property investment in China’s economic activity, this is an important shift.
In addition to financial and property market data, there is also other data confirming decelerating economic activity in China. The government reports that, in October, industrial production was up 5.9 percent from a year earlier, a little better than the record-low growth of 5.8 percent in the previous month.39 The latest data included a 6.1 percent increase in manufacturing output. Also, it is reported that retail sales were up 8.6 percent in October versus a year earlier, the second lowest in 18 years. Fixed asset investment in the first 10 months of the year was up 5.7 percent from a year earlier,40 an improvement over the last two months, but still a historically low rate of growth. Public sector investment was up only 1.8 percent, while private sector investment was up 8.8 percent.
These data indicate a Chinese economy that has substantially decelerated in recent years. The only positive is that exports have lately grown strongly. However, given trade tensions with the United States, it is not clear if this can be sustained. Also, given that the easing of monetary policy does not appear to be having the desired impact, there is now talk about the government easing fiscal policy further, possibly through another tax cut, in order to stimulate the economy.
China’s central bank, the People’s Bank of China (PBOC), is evidently concerned that the drop in the value of the renminbi over the past year is causing problems for China. These include increased tensions with the United States, the potential for higher inflation, and likely problems servicing dollar-denominated debts. As such, it is not surprising that the latest statement from the central bank on currency policy has shifted. Specifically, previous statements by the PBOC indicated that the bank would “increasingly allow market forces to determine the exchange rate.”41 The latest statement, however, says that the PBOC will “reinforce macro-prudential management to keep the yuan exchange rate at reasonable and equilibrium level, if necessary.” This implies that the PBOC will intervene in currency markets in order to prevent a sharp depreciation. That will entail further sales of reserves. In October, there were substantial sales.42 Given that President Xi and President Trump are set to meet in December in Argentina, it is likely that the policy of stabilizing the currency will continue until at least the end of the year. However, if the United States imposes higher tariffs in January as planned, potentially leading to new troubles for the Chinese economy, it will make sense for China to allow the currency to fall further, especially as part of a further easing of monetary policy.
Meanwhile, some analysts are concerned about the growing volume of dollar-denominated debt held by Chinese businesses.43 According to estimates from a Japanese investment bank, there are US$12 trillion worth of dollar-denominated debts held by investors outside the United States. Of this, roughly US$3 trillion is held by Chinese investors. Moreover, the Chinese portion has risen faster than any other major emerging market’s portion. There are two concerns.44 First, as the dollar rises in value, investors will face greater difficulty in servicing these debts. In addition, as US interest rates rise, rolling over such debts will become more expensive. The renminbi has fallen about 11 percent against the dollar since March and is hovering near the psychologically important level45 of 7 renminbi per dollar. If it moves beyond that level, it could set off further sales of Chinese currency, thereby either causing it to fall in value or leading the central bank to sell more foreign currency reserves in order to stabilize the exchange rate. Second, as the trade war intensifies, it is possible that Chinese businesses will take on even more dollar-denominated debts. In addition, there is concern about the so-called carry trade in which Chinese borrow cheaply in dollars and then invest in high-yield Chinese securities.46 However, this trading strategy becomes unprofitable when the dollar rises in value and when US yields rise as well. It is likely that the Chinese authorities will consider these issues as they contemplate currency policy. They are likely wont to allow a sharp depreciation of the renminbi because of these and other concerns.
Inflation in the 19-member eurozone accelerated in October, with consumer prices up 2.2 percent from a year earlier.47 This was the highest rate of headline inflation since December 2012. However, when volatile food and energy prices are excluded, core inflation was 1.1 percent. This was relatively high compared to the past year, but not ruinously so. Core inflation was 1.1 percent in three of the last 12 months. In most months, it was lower. The European Central Bank (ECB) has set an inflation target of 2.0 percent. Consequently, underlying inflation still remains well below the ECB target. This is likely due to continued high unemployment in many eurozone countries, which has the effect of stifling wage growth.
At the same time, average wages in the eurozone have indeed accelerated in recent months, auguring for higher inflation. Still, indications of a slowdown in economic growth suggest that wage pressures could soon abate. In addition, the recent decline in energy prices will ultimately feed through to lower headline inflation and even have an indirect dampening effect on core inflation. Meanwhile, headline inflation in October was 2.4 percent in Germany, 2.5 percent in France, 2.3 percent in Spain, 1.9 percent in the Netherlands, 1.8 percent in Greece, and 1.1 percent in Ireland. In Italy, October data was not available, but headline inflation was 1.5 percent in September. The lower inflation in Italy likely reflects the relative weakness of the Italian economy.
Oil prices have fallen sharply in the past six weeks, hitting the lowest level since late-2017.48 This came about as investors reevaluated the economic and political situation. The drop in recent weeks reflects several factors. These include the observation that the global economy is in deceleration, the expectation that the US economy will soon decelerate as the Federal Reserve tightens, the fact that US crude output continues to rise rapidly, expectations that the Organization of the Petroleum Exporting Countries (popularly known as OPEC) will not be successful in limiting production, and the effect of a rising value of the US dollar. After all, there is traditionally an inverse relationship between the value of the dollar and the price of oil. When the dollar rises, the non-dollar price of oil rises, thus suppressing demand outside the United States. Prices had previously risen due to an agreement between Saudi Arabia and Russia to reduce production, the US withdrawal from the Iran nuclear deal that led to a drop in Iranian output, and concerns about instability in several locations, such as Venezuela and Nigeria.
Yet it appears that the factors contributing to price weakness are now overwhelming the other factors. Moreover, it is reasonable to expect that, although they will be volatile, prices will likely fall further in the coming year as the global economy slows down and US output continues to rise.
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.49 Yet both President Trump and Democrats tried to nationalize Tuesday’s midterm elections, making the results to some extent a referendum on Trump himself.50 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.51 Exit polls notwithstanding, it is too early to definitively say what motivated voters,52 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.53 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.54
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.55 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.56 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.57 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 chamber58—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.59 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.60 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.61 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.62
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.63 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.65 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.66 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.67 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 debate68 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.69 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.70
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.74 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.75 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,76 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.”77 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.78 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.79 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.
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