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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Last week, the US Commerce Department sent to President Trump the results of its investigation into whether automotive imports represent a threat to national security. While the conclusions were not made public, there were press reports that the Commerce Department determined that automotive imports are a threat to national security.1 As such, the president has 90 days to decide whether to impose punitive tariffs of up to 25 percent. Currently, the US tariff on imported automobiles is 2.5 percent and the European tariff on imported automobiles is 10 percent.2 The US decision on tariffs had been postponed last year after an agreement between the United States and the European Union (EU) to put new tariffs on hold while negotiations take place. Yet there has not been progress on resolving the dispute. The US side had sought to compel the EU to lower its automotive tariffs and commit to reducing automotive exports to the United States. The US administration has already implemented a little-used section of US law, known as Section 232, to restrict trade in steel and aluminum based on national security considerations. So unusual is this that several leading Republican members of Congress are now seeking to change the law to limit the president’s discretion in such matters.3
Meanwhile, the imminent decision on automobiles is generating considerable consternation in Europe. An EU official said, “Were this report to translate into actions detrimental to European exports, the European Commission would react in a swift and adequate manner.”4 In other words, there would be retaliation. Meanwhile, German Chancellor Merkel noted that BMW’s largest factory is in the United States. It makes cars for the US market and for export, and it depends on imported components that would be subject to tariffs if the United States imposes them. She said, “If such cars are suddenly a threat to US national security then I find that shocking.”5
Germany’s Ifo Institute, a leading think tank, said that, if the United States imposes permanent tariffs of 25 percent on imported automobiles, it would result in a 50 percent decline in German car exports to the United States, and that 60 percent of the impact of any new tariffs would fall on Germany’s car industry. In addition, the German Automotive Association (popularly known as VDA) said that German automotive producers are responsible for 113,000 jobs in the United States6 and are the largest exporters of vehicles from the United States. Finally, the US-based Center for Automotive Research estimates that a 25 percent tariff on all automotive imports (except for imports from Canada, Mexico, and South Korea, which are covered by other trade agreements) would lead to the loss of 370,000 jobs in the United States and 1.3 million fewer cars sold in the United States due to higher prices. About 48 percent of the cars sold in the United States are imported, but German imports account for only 3 percent of cars sold in the United States. More than a third of cars sold in the United States are made in the United States by foreign automotive companies, many of which use imported parts. In addition, there are many cars made in the United States by foreign companies that are exported.
While the focus of the debate on automotive trade has involved Europe, Japan is concerned that its automotive exports could be at stake. Having secured a free trade agreement with the EU, Japan is now intent on having such an agreement with the United States.7 Moreover, Japan is worried that in the absence of negotiations on such a deal, Japan will be vulnerable should the United States choose to impose tariffs on imported automobiles and automotive parts. In September of last year, President Trump and Prime Minister Abe agreed that as long as trade negotiations between the two countries are taking place, the United States would hold off on imposing new tariffs on Japan. Thus, Japan is currently seeking to commence formal negotiations as soon as possible, and especially before President Trump visits Japan in May as scheduled. The Japanese view is that once negotiations begin, the United States will not impose tariffs on Japan, even if it does impose tariffs on automotive imports from Europe. Meanwhile, the two sides have already begun discussing what goods and services will be covered in upcoming trade talks. It is likely that the focus will be on automotive and agricultural trade. Japan is hoping that a bilateral deal might mimic elements that were embedded in the Trans-Pacific Partnership (often called the TPP), from which the United States withdrew.
When the Federal Reserve announced in January that it was putting interest rate increases on hold as part of a strategy of being “patient,” investors were pleased and asset prices rose. Last week, the Fed released the minutes of the meeting in January8 at which this decision was made, providing further insight into the thinking of Fed policymakers and offering a glimpse at where they may be headed.
The Federal Open Market Committee (FOMC), the Fed’s primary policy body, decided in January that it will soon stop reducing the size of its balance sheet. This “quantitative tightening,” which is the reverse of the quantitative easing that had previously taken place, has likely contributed to a tightening of credit market conditions. The Fed is evidently keen on stabilizing credit market conditions. It is also uncertain about the potential impact of its policy and wants more information before continuing down this path.
The minutes released indicate that the FOMC sees the US economy as being quite strong. However, the members see a number of potential headwinds, thereby indicating a need to pause and await better information about where things are going. Specifically, the FOMC minutes noted that “Members noted that financial conditions had tightened, on net, since September, and that global growth had moderated; members also observed that a number of uncertainties, including those pertaining to the evolution of policies of the US and foreign governments, still awaited resolution. However, members continued to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective as the most likely outcomes for the U.S. economy in the period ahead. In light of global economic and financial developments and muted inflation pressures, the Committee could be patient as it determined what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.” In other words, the Fed needs more information before determining next steps. However, the statement did not suggest that the Fed intends to reverse course.
The minutes also state that “A patient posture would allow time for a clearer picture of the international trade policy situation and the state of the global economy to emerge and, in particular, could allow policymakers to reach a firmer judgment about the extent and persistence of the economic slowdown in Europe and China.” Finally, the minutes state that “It was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year; several of these participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year.” Thus, it appears that there remains within the FOMC a view that further rate increases could be necessary. The euphoric view of some investors that the Fed is now engaged in a reversal of policy is probably not the right interpretation of events. Rather, the Fed appears to be truly on hold and remains amenable to further rate increases. Nothing in the minutes suggest a likelihood that the Fed will cut rates anytime soon. However, the futures market has lately inferred that investors see some likelihood that the Fed will cut rates in 2019.
As negotiations between the United States and China go down to the wire, it is now reported that one of the US demands is that China maintain the stability of its currency.9 Interestingly, the United States has long complained that China manipulated its currency, holding down the value in order to boost export competitiveness. In recent years, China has often allowed the currency value to be determined by market forces rather than by direct intervention. Indeed, the renminbi fell in value in 2018 largely because of investor worries about the trade war between China and the United States. If China agrees to the US demand, it will actually represent a victory for currency manipulation in that China will be compelled to target the value of the currency rather than allow market forces to operate. In any event, it is reported that the United States sees the use of tariffs as a potential mechanism for enforcing a currency agreement. That is, it may want the agreement to specify that, if the renminbi depreciates by a certain amount, the United States would then be able to impose tariffs meant to offset any competitive gain resulting from currency depreciation.
There is precedent for having a currency arrangement in a trade agreement. The recently negotiated the United States-Mexico-Canada Agreement (also called USMCA), which will replace NAFTA subject to Congressional approval, includes a provision whereby the three parties pledge not to engage in devaluation for the purpose of boosting competitiveness. In the case of China, the problem is that there will be times when a depreciation of the currency will actually be appropriate. It can be argued that, in recent years, the renminbi was overvalued, thereby hurting China’s export-related industries.
Meanwhile, the United States has decided to postpone the March 1 deadline.10 Previously, the United States had said that if a new trade deal was not completed by March 1, then tariffs will rise precipitously on March 2. However, President Trump now says that the deadline will be extended. He said, “I know that China would like not for that to happen. So I think they are trying to move fast so that doesn’t happen. But we’ll see what happens. I can’t tell you exactly about timing.” He also said that “it’s more likely that a deal will happen. The relationship is outstanding. It is the strongest it has ever been.”11 It is also reported that Trump and his Chinese counterpart, President Xi, will meet sometime in the next few weeks and that, consequently, the date of their meeting could be the new deadline.
At the same time, Trump’s principal trade negotiator, Robert Lighthizer, recently said that the March 1 deadline is a “hard deadline,” perhaps with the intent of compelling the Chinese to make concessions quickly. For China, it is not clear what to make of the conflicting signals from Trump and his chief negotiator. Is it a “good cop, bad cop” situation, or is there simply a lack of coordination? Moreover, if China wants to please Trump, it likely needs to commit to increasing imports from the United States. If it wants to please Lighthizer, however, it will have to agree to structural changes, such as a reduction in subsidies for state-owned enterprises. And if Lighthizer is not pleased, will Trump agree if Lighthizer recommends following through with higher tariffs?
The slowdown in China’s economy is reverberating throughout the region,12 causing a significant decline in the exports of other Asian countries to China. For example, Singapore’s non-oil exports to China plummeted 25.4 percent in January compared to a year earlier. Singapore’s overall non-oil exports were down 10.1 percent in January versus a year earlier, clearly led by the sharp decline in exports to China. Singapore is a major trading nation, with exports and imports very high relative to GDP, a reflection of the fact that the city-state is a trading hub that processes goods from other countries. Thus, the health of Singapore’s trade sector is often a good proxy for the health of Asia’s economy, or even the global economy. Meanwhile, the Asian Development Bank said that economic growth in Southeast Asia’s five largest economies (Singapore, Malaysia, Thailand, Indonesia, and the Philippines) decelerated in 2018,13 in large part due to the slowdown in China and its impact on trade in the region.
Japanese exports to China fell 17.4 percent in January versus a year earlier.14 This included a 25 percent drop in exports of chip-making equipment and a 39 percent decline in exports of electronic circuits. The weakness of Chinese imports of Japanese goods was due, in part, to weak domestic demand and, in part, to weak global trading, itself the result of trade tensions between the United States and China, which affected Chinese-led supply chains. This was evident in the fact that Japanese exports were down 11.6 percent to South Korea, 11.0 percent to Taiwan, and 18.7 percent to Australia.
In addition, it is reported that other countries in Asia are also experiencing a weakening of exports.15 South Korean exports to China fell 19 percent in January versus a year earlier. This was largely the result of a sharp drop in exports of semiconductors. Taiwan’s exports to China fell 7.5 percent in January versus a year earlier, and exports to China from Thailand fell 7.3 percent. Only Vietnam among major countries in the region saw an increase in exports to China. The decline in exports from these countries was principally due to weakness in Chinese demand for technology-related products. China is a major location for final assembly of technology products that rely on imported components from factories in other Asian countries. Due to uncertainty about trading relations between the United States and China, it is reported that some final assembly of technology products is shifting from China to other countries, with products then being directly exported to the United States. For example, exports from Taiwan to the United States increased 21.2 percent in January from a year earlier, largely because some technology companies chose to engage in final assembly in Taiwan rather than outsource it to China. Interestingly, the tariffs on Chinese imports that the United States has implemented or threatened have not caused production to revert to the United States as intended. Rather, these tariffs are causing production to shift from China to other Asian countries. If tariffs continue and/or rise, and are perceived as relatively permanent, it is likely that many companies will further rearrange their supply chains in order to avert tariffs.
The weakness of the Chinese economy was evident in the latest data on automotive sales. It was reported that in January, sales of automobiles in China were down 17.7 percent from a year earlier.16 This was the seventh consecutive month of declining sales and the biggest decline in seven years. It left January sales at their lowest level since 2012. Sales of all vehicles were down 15.8 percent in January versus a year earlier. China has the world’s largest automotive market by far, and many of the world’s leading companies rely heavily on the Chinese market. Thus, the slowdown in Chinese demand is likely to reverberate around the world. There are a number of factors that explain the weakness in Chinese auto sales. First, the economy is clearly decelerating. Second, the government has cracked down on peer-to-peer lending channels that had been heavily used by consumers seeking automotive loans. Interest rates on consumer loans have increased accordingly. Third, consumer usage of public transport and ride-sharing apps has been increasing considerably. Meanwhile, demand for electric vehicles continues to rise. In addition, concerns about air pollution and traffic congestion mean that there might be limits to how much more the Chinese automotive market can grow without causing serious negative side effects. As sales of new cars decline, it is likely that the market for used cars will grow rapidly.
Another indication of Chinese economic weakness was a sharp deceleration in producer prices.17 It is reported that, in January, producer prices were up only 0.1 percent from a year earlier. This was the slowest growth since September 2016, and the seventh month in which producer price inflation decelerated. Prices were down 0.6 percent from the previous month. The weakness of producer prices was likely due to a weakening of domestic orders and a subsequent rise in inventories. Weak producer prices are likely to feed into slower consumer price inflation as well as having a negative impact on corporate profitability. Although low inflation gives the central bank greater room to ease monetary policy, the central bank will likely be wary of allowing a further acceleration in the volume of bad debt.
The worsening performance of the eurozone economy was evident in the latest data on industrial production. The European Union (EU) reports that industrial production in the 19-member eurozone fell sharply in December, hitting a level last seen in early 2017.18 Specifically, output was down 0.9 percent from November and down 4.2 percent from a year earlier. The latter decline was the steepest since November 2009, during the last recession. Notably, production of capital goods fell 5.5 percent in December versus a year earlier. This indicates weak domestic investment plans and/or overseas demand for capital goods. It is likely that both are true. Compared to a year earlier, December output was down 3.9 percent in Germany, 1.7 percent in France, 5.5 percent in Italy, 6.7 percent in Spain, 4.2 percent in the Netherlands, and 19.8 percent in Ireland. Among the non-eurozone countries in Europe, production was down 1.2 percent in the United Kingdom, up 2.3 percent in Sweden, and up 2.7 percent in Poland.
Meanwhile, the EU published the first estimates of fourth-quarter GDP growth by country. Overall growth in the 19-member eurozone was weak in the fourth quarter, with real GDP up 0.2 percent from the previous quarter and up 1.2 percent from a year earlier.19 The weakest countries were Germany and Italy. In Italy, real GDP fell for the second consecutive quarter, down 0.2 percent from the previous quarter. Two quarters of contraction is often seen as the definition of a recession. In the case of Germany, although real GDP had declined in the third quarter, it was simply unchanged in the fourth quarter. Thus, Germany’s economy has not actually grown since the second quarter. Overall, Germany’s real GDP in the fourth quarter was up only 0.6 percent from a year earlier while Italy’s was up only 0.1 percent from a year earlier. Growth was stronger elsewhere, with real GDP in France up 0.3 percent for the quarter and up 0.9 percent from a year earlier. Spain did quite well, with real GDP up 0.7 percent for the quarter and up 2.4 percent from a year earlier. The strongest economies were in Central and Eastern Europe, with rapid growth taking place in Cyprus, Latvia, Lithuania, Romania, Hungary, Slovakia, and Poland. Within Western Europe, there was strong growth in Denmark and Finland. The weakness of Germany is of most concern given that it is the largest economy in Europe and an important engine of growth for the region.
The eurozone’s misfortunes have come quickly and somewhat surprisingly. The European Central Bank (ECB) has maintained an easy monetary policy characterized by historically low interest rates, several countries have engaged in more fiscal spending, and the region has lately benefitted from lower energy prices.20 Moreover, employment has continued to grow, wages have increased, and credit market activity has accelerated. Thus, it is not entirely clear why Europe has slowed so much. Among the possible explanations are weak demand from China, which purchases a lot of capital goods from Germany and other eurozone economies; the disruptive shock of new rules regarding diesel vehicles; the disruptive effects of the yellow vest protests in France; the rise in borrowing costs in Italy following the seating of a euro-skeptic government; the uncertainty fueled by Brexit; and the uncertainty fueled by the US threat of protectionist actions.
With Europe and China both decelerating, two of the three largest economies in the world appear to be in trouble. But unlike China, Europe is not in the midst of a concerted and centralized effort to stimulate activity. On the contrary, there are factors that might help Europe avoid further trouble. These include a weakening euro, which will boost export competitiveness; declining energy prices; and more government spending in Germany, France, and Italy. In addition, a favorable resolution of the Brexit issue could be helpful to the eurozone. Still, there remain areas of uncertainty. Of particular concern is the global trading environment, especially in light of a trade dispute between the United States and China as well as possible US plans to restrict imports of automobiles. This is likely already having a negative impact on investment and trade flows in Europe. Resolution of this issue would be helpful to Europe’s economy. At the same time, Oxford Economics estimates that a full-blown trade war would reduce annual GDP growth in the eurozone by 0.7 percentage points for each of the next three years.
The US job market continues to be historically tight, according to the US government’s Job Openings and Labor Turnover Survey (also called JOLTS). The government reports that, in December, the number of job openings hit an historic high of 7.3 million, up from 5.7 million one year earlier.21 The number of job openings exceeded the number of unemployed by more than 1 million. The number of people hired in the US job market increased from 5.5 million in December 2017 to 5.9 million in December 2018. Meanwhile, the government also reports that the job openings rate (the share of available jobs that are unfilled) was 4.7 percent in December, up from 3.7 percent a year earlier and matching the historic high. By industry, the highest job openings rates were in accommodation and food services (6.7 percent), professional and business services (5.9 percent), and health care (5.7 percent). The lowest rates were in education (2.6 percent), real estate (2.8 percent), and nondurable manufacturing (2.8 percent).
The tightness of the job market has already led to an acceleration in wages, although wage inflation remains only marginally higher than consumer price inflation. It is likely that labor costs are rising faster in those industries with higher rates of job openings. The variation of job openings rates likely reflects skills mismatches in the labor market. Highly skilled workers are in great demand, but their supply is not commensurate with that demand. This partly explains the widening degree of income inequality in the economy.
Despite the tight US job market, there is a widespread view22 that the US economic cycle has passed its peak and that a downturn could be imminent. The question on the minds of many investors is what will be the key factor that will drive that downturn. In the past 30 years, downturns largely came about because, after the Federal Reserve raised interest rates, the existence of structural problems in financial markets was revealed, leading to panic selling, sharp declines in asset prices, and constriction of credit market activity. Will that happen again? And, if so, what will be the source of trouble? Many investors are now focused on the market for leveraged corporate loans.23 These are loans made to companies that are already highly indebted and/or have low bond ratings. The volume of such loans has doubled in the past year and has contributed to the sharp overall rise in corporate borrowing. Indeed, corporate debt is now 46 percent of GDP, the same level as just prior to the last recession. Moreover, about half of investment-grade debt is rated BBB, the level just above junk status. And the volume of the BBB debt has increased five-fold in the last 10 years. In addition, there has been a sharp increase in the amount of non-bank lending to corporations through private equity companies and others.
This rise in “private debt” has led to concerns about the degree of transparency in the market.24 Thus, many observers are concerned about the quality of corporate debt in the midst of rising borrowing costs and slowing economic growth. Moreover, while in the past most corporate debt was held by passive investors, such as pension funds, a rising share is now held by active investors in the form of exchange-traded funds. If these investors become spooked and start selling, the funds will need to sell illiquid bonds, thus potentially leading to a sharp drop in prices and a possible seizing up of the bond market. Interestingly, despite a huge increase in corporate borrowing, there has not been a commensurate increase in corporate investment. Rather, it seems likely that much of this new debt was used to fund share buybacks and private equity or hedge fund transactions.
What is the likely outcome of the trade discussions between the United States and China? The answer depends, in part, on how each side perceives the interests of the other. The US side evidently believes that China will make significant concessions in order to avoid further increases in tariffs, especially given that the Chinese economy appears to be suffering from the existing ones. President Trump has publicly alluded to China’s economic problems, indicating that he has them where he wants them.25 Thus, he might think that he can extract significant concessions from China. But what about China’s leaders? How do they perceive the interests of the United States? This is hard to know because China’s leadership does a good job of keeping its cards close to its vest. Still, one can imagine what they might be thinking if one considers what happened in the case of the North American Free Trade Agreement (NAFTA). There, the US president said that NAFTA was “the worst trade deal ever.”26 Then he accepted a modest revision, which mainly had to do with domestic content for automobile production, and claimed that the new United States-Mexico-Canada Agreement (popularly called the USMCA) is a great trade deal.27 From China’s perspective, the United States appears willing to accept modest changes and claim victory. Thus, China might not have a strong incentive to make substantial concessions. Moreover, China keeps hearing that the United States wants to reduce its trade deficit with China.
Of course, China can agree to purchase more things from the United States, simply by purchasing fewer of those things from other countries. Yet the net effect on the United States will be that while its deficit with China will decline, its deficit with other countries will increase, and its overall deficit will likely remain unchanged. The same will be true for China. In the end, nothing significant will have changed, but at least China will have pleased US negotiators. Thus, China likely has an incentive to agree to divert trade toward the United States. On more substantive issues, such as subsidies for state-run companies, China is less likely to concede anything that would entail changes to its own economic structure. Chinese leaders often emphasize the historically dominant role of state companies in China’s economy.28 Indeed, it has been reported that the issue of subsidies is one of the principal obstacles to completing a deal.29 It was also reported that the Chinese are attempting to focus the discussions on Chinese promises to boost purchases of US commodities. The question, then, is what will the US side accept? US trade negotiator Robert Lighthizer is said to be focused on the structural issues while others in the US administration are more concerned about the trade balance.
The British economy has decelerated considerably. The government reports that in 2018, real GDP grew only 1.4 percent from the previous year, the slowest rate of growth since 2012.30 Moreover, growth worsened as the year progressed, with real GDP growing at an annualized rate of only 0.7 percent in the fourth quarter. The UK government estimates that economic activity actually declined in December as the year came to a close. The weakness of growth in 2018 was largely due to a sharp decline in business investment. For all of 2018, investment fell 0.9 percent, the sharpest drop since the recession in 2009. In the fourth quarter, business investment fell at an annualized rate of 1.4 percent and was down 3.7 percent from a year earlier.31 The latter figure was the worst since the first quarter of 2010. This was the fourth consecutive quarterly decline in business investment. This weakness has been attributed to uncertainty about Brexit alongside global political risks and weakening trade. Meanwhile, exports declined in the fourth quarter versus a year earlier. This was despite the weakness of the pound, which has improved the competitiveness of British exports. Yet with investment weak, businesses have evidently not invested in boosting export capacity or efficiency. Finally, British industrial production declined in December, falling 0.9 percent from a year earlier. The manufacturing component was down 2.1 percent. The latter measure has not increased since August. Within manufacturing, output was down 6.9 percent for machinery and equipment, 11.1 percent for electrical equipment, 10.8 percent for metals, and 3.1 percent for transport equipment.32
Given that activity declined in December, some analysts now fear that the British economy could be headed into a recession early in 2019, especially if there is not a satisfactory resolution of the Brexit quandary. Chancellor of the Exchequer Philip Hammond said that the British economy “has grown every year for the past nine years.”33 He also attributed the fourth quarter weakness to Brexit uncertainty, suggesting that a resolution of the issue in the next 50 days would result in an economic rebound. That is possible, although Britain is also facing other headwinds, such as weaker growth in Europe and China. If the UK were to tip into a recession, the traditional remedy would be for the Bank of England (BOE) to cut interest rates and for the government to boost spending. One political problem is that interest rates are already historically low, thus limiting the BOE’s ability to cut rates. Rather, the BOE could revert to asset purchases, although this would be politically controversial. As for the government, it now has a far larger debt as a share of GDP than prior to the last recession. This does not mitigate against increased spending or cutting taxes, but also suggests a potential political constraint on fiscal easing. If, in a recession, there is a failure to implement monetary and fiscal policy easing, the end result could be a deeper and longer recession than otherwise.
China’s birth rate has not responded to the relaxation of the one-child policy that took place in 2014.34 Instead, the number of births continues to decline. In 2018, there were 15.23 million births in China, the lowest number since 1961, and lower than 17.86 million in 2016 and 17.23 million in 2017. There had been an expectation that once urban families were permitted to have more than one child, there would be a surge in births. The opposite has happened. Evidently, young urban families are comfortable with the lower cost of having fewer children. Moreover, the cost of urban housing has risen, thus mitigating against having a larger number of people in each household. Finally, many urban families are two-income earners who rely on grandparents to assist with child rearing. This might be less feasible with a larger number of children.
In any event, China faces daunting demographics. Currently, the ratio of workers to retirees is about 2.8, but this figure will likely be cut in half by the middle of this century. In the United States, by contrast, the ratio is also 2.8 currently, but will decline more slowly in the years ahead.35 Unless the birth rate rises (or China allows significantly greater immigration), the country will face several consequences. Economic growth will be slower as the working-age population declines; the cost of providing pensions and health care for the elderly will place an increasing burden on workers, possibly forcing a sharp rise in the age of retirement; and China’s overall population will start to fall.
With the United States having imposed substantial tariffs36 on Chinese imports, the question arises as to what impact this has had on trade volumes and the prices of traded goods. A new analysis conducted by the Institute of International Finance (IIF)37 offers some insight into what has happened—and what might happen should the trade war intensify. It is helpful to recall what exactly the United States did. Early in 2018, the United States imposed 25 percent tariffs on US$50 billion in imports from China. Later in the year, it imposed a 10 percent tariff on an additional US$200 billion in imports from China. Moreover, the US administration says it will boost these tariffs to 25 percent in March 2019 if a new trade deal cannot be achieved.38
Despite having imposed new tariffs on half of imports from China, the reality is that imports from China continue to grow.39 Does this mean that the tariffs have not had an impact? The answer is no. Rather, the impact takes time. The IIF found that for the 25 percent tariffs on the first US$50 billion in imports, there has already been a sizable effect, with imports of those produces falling sharply. The US$200 billion in imports on which the 10 percent tariff were imposed accelerated when the list of goods was announced as importers front-loaded orders in order to avoid tariffs. Imports also grew even after tariff imposition, largely because importers engaged in front-loading in order to avoid expected future tariff increases.
The IIF believes, however, that even in the absence of future tariff increases, imports of the US$200 billion will likely decelerate due to the impact of existing tariffs. Also, there is evidence40 that Chinese exporters cut their prices in order to offset the tariff impact. This was made possible, in part, by the sharp decline in the value of the renminbi. The IIF analysis suggests that, if the United States imposes further tariffs on China as threatened, imports will likely decline sharply. Finally, the IIF says that, due to Chinese retaliatory tariffs on the United States, Chinese imports from the United States are declining, leading to an increase in the bilateral US trade deficit with China. The decline in trade volumes is already having a negative impact on cross-border investment, with Chinese direct investment in the United States down very sharply.
With the US-China trade war under way, and with evidence of declining trade volumes between the two economic giants, it is likely that some of the lost trade will be diverted elsewhere. Now, the UN Commission on Trade and Development (UNCTAD) says trade diversion from the US-China dispute41 is principally benefitting Europe. Specifically, a new analysis from UNCTAD says that the tariffs imposed by the United States on China will mostly not lead to a return of production to the United States. Rather, it will lead to a diversion of trade to other countries, with the European Union (EU) being the principal beneficiary. However, UNCTAD also says that Canada, Mexico, Brazil, Vietnam, India, Australia, and Japan will benefit as well. Additionally, UNCTAD believes that in a prolonged trade war, about 82 percent of US imports from China that are subject to tariffs would be shifted to other countries. Likewise, it says that China’s tariffs on the United States will lead to a substantial diversion of trade to other countries, especially Europe. UNCTAD concludes that “while bilateral tariffs are not very effective in protecting domestic firms, they are very valid instruments to limit trade from the targeted country.
The effect of US-China tariffs would be mainly distortionary. The US-China bilateral trade will decline and be replaced by trade originating in other countries.”42 In addition, UNCTAD said that the diversionary impact of tariffs will depend, in part, on whether businesses perceive them to be permanent. In other words, if businesses expect tariffs to be permanent, that would influence the location of their investments.
Of course, it should be noted that, although some countries might gain from US tariffs on China, many could be adversely affected. Asian countries that contribute to Chinese-led supply chains could lose substantial export revenue, according to UNCTAD. In addition, if the trade war between the United States and China leads to a decline in economic growth in both countries, that would have negative consequences for the rest of the world. Also, if a drop in US imports from China leads to a surge in imports from elsewhere, the US administration could react by imposing tariffs on other countries. Finally, to the extent that the US tariffs on China result in higher prices paid by US companies that import components, it could mean a loss of competitiveness for US companies.
Exports from the United States have stopped growing.43 The dollar value of exports of goods and services had steadily risen from early 2016 until early 2018. However, exports have stagnated since March 2018. The value of exports in November 2018 was roughly the same as in March and below the peak reached in May. When adjusted for price changes, real exports of goods were unchanged from March to November 2018. Prior to that time, real exports of goods had been growing. Finally, exports of goods were up 3.5 percent in November versus a year earlier. This was a modest level of growth that masked a sharp divergence in performance by country of destination. By country, exports were up 6.0 percent to Mexico, 14.3 percent to the EU, 18.5 percent to Japan, and 10.7 percent to South America. However, exports to China were down 32.1 percent while exports to Canada were down 1.0 percent.
It is likely that the trade tension between the United States and China had an outsized impact on the overall direction of US exports. In addition, it should be noted that overall imports into China have declined recently,44 reflecting the weakening of the Chinese economy following last year’s tightening of monetary policy. At the same time, it is notable that Chinese imports from the United States have fallen far more sharply than imports from other countries.
Recently, US equity prices fell after US President Trump indicated that he will not meet with China’s President Xi before the March 1 deadline for resolving the two countries’ trade dispute.45 Based on Trump’s previous statements, investors had been led to believe that a meeting would take place, suggesting that a deal was imminent. The fact that a meeting will not take place led investors to downgrade their expectations for a deal. If no deal is achieved, the United States has threatened to boost the tariff on US$200 billion in imports from China from 10 percent to 25 percent. It has also suggested that it will impose new tariffs on all remaining Chinese imports. Such action will likely lead to higher prices paid by US consumers and businesses, higher costs for US businesses that import components from China, and retaliation by China. The latter would have a negative impact on US exports. By reducing trade volumes, the new tariffs would likely have a negative impact on business investment on both sides of the Pacific, especially investment related to global supply chains. All of these things would likely mean slower economic growth in both the United States and China.
One of the important but relatively underreported aspects of the US trade policy in the past two years has been the United States’ effort to reduce the power of the World Trade Organization (WTO). Specifically, the US administration has refused to approve the appointment of new members to the WTO’s dispute resolution panel, which adjudicates trade disputes between countries and enforces the rules-based trading system. If the number of members on the panel falls below a certain threshold, which may soon happen, the panel will no longer have the power to make rulings. If that happens, the WTO will essentially become a paper tiger. The United States says that it is attempting to force other members of the WTO to accept changes to the structure of the organization.
Critics, however, have said that the United States appears to be keen on simply undermining the rules-based multilateral trading system and hopes to revert to a system based on bilateral relations between countries. Whichever is true, it turns out that the United States has been the most active user of the dispute-resolution panel. A new study found that, since 1995 when the WTO was created, the United States initiated 123 complaints, more than any other member.46 Next in line was the EU, which initiated 99 complaints, followed by Canada (39), Brazil (32), and Japan and Mexico (each 25). China initiated 20 complaints. Moreover, the United States has been at the receiving end of the most complaints, with 152, followed by the EU with 85 and China with 43. Finally, in the vast majority of cases initiated by the United States, it received a positive ruling by the panel.
Bank of England Governor Mark Carney is predicting that the British economy will grow 1.2 percent in 2019—the slowest growth since 2009. As recently as November, Carney predicted growth in 2019 of 1.7 percent. The slower growth is expected to come, in part, from a decline in business investment and a sharp slowdown in exports. He said that, even a soft Brexit would entail a slowdown in growth, although he expects that the economy would then revive in the second half of the year. A no-deal Brexit, in contrast, could be more consequential and would likely lead to negative quarters of growth. Carney said that the likelihood of a no-deal Brexit has increased. He said, “The fog of Brexit is causing short-term volatility in the economic data, and more fundamentally, it is creating a series of tensions in the economy, tensions for business.”47 As for preparations for the no-deal Brexit, Carney suggested that many businesses are not ready. He said, “Although many companies are stepping up their contingency planning, the economy as a whole is still not yet prepared for a no-deal, no transition exit. In terms of our agent surveys, most recent surveys, of businesses and their preparedness, half of them say they are not ready. And the half that say they are ready... ready means we’ve done all we can.” Finally, when asked how the Brexit crisis had influenced his life, Carney said, “I don’t wake up in the morning any more. I wake up in the middle of the night.” Meanwhile the Bank of England policy committee voted to hold interest rates steady and indicated that there will be fewer rate increases in 2019 than previously expected.
Prime Minister May’s plan, following the Parliamentary defeat of her agreement with the EU, was to renegotiate the so-called “backstop” with the EU and submit a revised plan to the Parliament. However, the EU has said that it will not reopen negotiations of the Withdrawal Agreement. Thus, what is the strategy? Some have suggested that May simply wants to run down the clock in the hope that, at the eleventh hour, members of Parliament, in order to avoid the potentially catastrophic consequences of a no-deal Brexit, will hold their noses and agree to her existing plan.48
As for what happens after Brexit takes place, there is new information about what this will entail. Last week, the International Trade secretary, Dr. Liam Fox, confirmed to Parliament that renegotiations of the EU trade deals from which the United Kingdom currently benefits as a result of its EU membership have run into delays. If the United Kingdom leaves the EU without a deal, then its access to all of the 70 or so preferential trade deals with countries including Canada, Japan, Turkey, and South Korea will need to be renegotiated from scratch. If the United Kingdom leaves under the terms of the Withdrawal Agreement then the United Kingdom is seeking to “roll over” its access for the duration of the transition period, but cannot guarantee that Britain will be covered by most of the trade deals (strictly, the EU will notify other countries that, during a transition period, Britain should be treated as if it remains a member of the EU but cannot compel them to do so - and Britain would be legally bound to give the third countries all of the benefits of the existing trade deals).
The Chinese government is trying to kill zombies…zombie companies, that is. In December, the government said that it intends to close all so-called “zombie companies” by the end of 2020.49 A zombie company is a state-run company that is consistently unprofitable and kept open either through government subsidies or the rolling over of loans provided by state-run banks. The government estimates that there are about 2,000 zombies owned by the central government and as many as 10,000 zombies when including those owned by regional or local governments. Some private sector analysts believe that there are as many as 20,000 zombies. Closing a zombie entails delivering a shock to the economy as it means boosting unemployment and forcing banks to write off bad debts. This would ordinarily be done when the economy is strong. Yet China’s economy has weakened considerably.
So why do it now? The answer is that China badly needs to improve efficiency in order to meet the external challenges imposed by the trade war with the United States. Closing zombies will free up resources for more profitable uses. Rather than rolling over bad loans, banks will be encouraged to fund newer more efficient businesses, thereby boosting future economic growth. Closing zombies will reduce subsidies and cut excess capacity, thereby assuaging some of the concerns of the US government. And closing zombies will address the problem of excessive debt in the economy, thereby reducing the risk of financial turmoil. The industries with the greatest “zombie” problem are said to be steel and property. In the short term, closing zombies could be highly disruptive, even if the longer run consequences are positive. Still, the decision to close them came from the top. In a recent speech, President Xi Jinping said, “We must increase our efforts to appropriately handle the problems associated with zombie companies.”
The US Federal Reserve recently announced a reversal of monetary policy, with a decision to halt rate increases in light of lower inflation and signs of economic weakness. Following that, the Fed released data, which indicates that credit market conditions have shifted considerably in a way that points to potential problems, thus justifying the Fed’s shift in policy. The data for January comes from the Fed’s quarterly survey of banks. Specifically, the Fed data shows that banks have tightened their lending standards while demand for credit on the part of consumers and businesses has weakened.50 Here are some highlights of the new data.
The share of banks saying that they have tightened lending standards for commercial and industrial loans to large and middle market firms increased to the highest level since 2016. The Fed also reported a sharp decline in demand for such loans.
The share of banks that have increased the spread between their loan rates and their cost of funds increased to the highest level since the last recession in 2009.
The share of banks reporting willingness to make consumer installment loans fell to the lowest level since the last recession in 2009. Moreover, the share of banks reporting increased demand for consumer installment loans fell to the lowest level since the last recession.
These results are consistent with what often happens in the period just prior to a recession. The increase in spreads, in particular, is often an indication of trouble. It means that banks are becoming more cautious and that, as a consequence, private borrowers are facing higher costs of loanable funds. This, in turn, weakens demand. Thus, the decision by the Fed to stop tightening monetary policy can be seen as needed to stifle the deterioration of credit market conditions. Whether or not the Fed’s actions will be sufficient to prevent a further deterioration is hard to say. There are headwinds other than monetary policy that are influencing credit conditions. These include a high degree of leverage in the economy, weak overseas demand for American goods, and uncertainty created by trade policy and the recent US government shutdown.
One of the key economic trends that informed political debate in the United States in recent years was the loss of manufacturing jobs. On the left, it led to calls for more social spending, while on the right, it led to calls for restrictions on immigration. Leaders on both the left and the right called for trade restrictions. It is true that the number of jobs in the manufacturing sector fell sharply, from almost 20 million in 1980 to about 12 million just after the last recession. Moreover, nearly 6 million manufacturing jobs were lost between 2000 and 2010 alone. Most job losses took place during recessions, but the business cycle alone does not explain the longer-term loss. Rather, automation due to technological progress, as well as a shift of lower value-added processes to low-wage countries, explains much of the decline. However, it is worth noting that the manufacturing sector saw a gain of about 1 million jobs from 2010 to 2017.51
This was the biggest sustained increase in manufacturing employment since the 1960s. About a third of the increase was in the transportation equipment industry, mainly automotive. This represented a sizable recovery of the jobs that had been lost in the previous decade. It reflected improvements in productivity that enabled auto producers to effectively compete with lower wage countries. Other sectors that saw big job gains were fabricated metals and machinery as well as food processing. These three industries accounted for most of the manufacturing job increases since 2010. Notably, the current steep tariffs on imports of aluminum and steel threaten to undermine the improved performance of both automotive and machinery producers.
Finally, it should be noted that, although there have been job gains, many of the new jobs are different from the ones previously lost. Manufacturers have shifted the skills mix, placing greater emphasis on highly skilled workers. Thus, the less educated assembly line workers who lost their jobs in the past are not likely to be rehired. As such, their sense of being left behind, and the political consequence of that sentiment, continues.
Last week, the British Parliament gave the prime minister a remit to renegotiate the “backstop,” which is meant to prevent the creation of a hard border between Northern Ireland and the Republic of Ireland. Prime Minister May said that it is clear that no deal can pass the House with the existing backstop in place. Indeed, the existence of the backstop played a significant role in the historic failure of May’s plan to be approved. She likely hopes that, if she can get a different deal on the backstop, then she can obtain majority support for the remainder of the deal. She said that she wants “not a further exchange of letters, but a significant and legally binding change to the withdrawal agreement.” Yet there is precious little time remaining. Britain is set to exit the European Union (EU) on March 29. Meanwhile, European Council President Donald Tusk said that the EU is not willing to negotiate a change to the backstop provision, nor any other provision of the deal. European Commission President Jean Claude Juncker said that Britain’s attempt to renegotiate at this late hour risks a disorderly exit. He said that the EU ought to “prepare for the worst.”52 Meanwhile, the Parliament rejected a proposal offered by Labour member Yvette Cooper that would have allowed the House to vote to extend the Brexit deadline beyond March 29.
Given that the backstop has been the greatest source of division within the British Parliament concerning Brexit, it is worthwhile to clarify exactly what the backstop entails.53 The 1998 Good Friday Agreement ending the armed conflict in Northern Ireland effectively eliminated the border between Ireland and Northern Ireland, the latter being part of the United Kingdom. It meant entirely free movement of goods and people across a frictionless border, and was possible because both the United Kingdom and Ireland were members of the EU. With Britain leaving the EU, there was concern that, were Britain to exit the customs union, a new border would take effect, thereby negating the gains from the peace agreement. The intention of both sides is to negotiate a trade agreement that will prevent any new border emerging, but the backstop is intended to be an insurance if no such deal can be agreed, or if it takes longer than planned.
The backstop has two legs. The first sees the entirety of the United Kingdom, including Northern Ireland, entering into a “customs territory” with the EU, which can only be ended by mutual agreement. The second involves pages of regulations that will only apply in Northern Ireland, not the rest of the United Kingdom, for as long as the backstop persists. This was seen as unacceptable to Brexiters. From their perspective, the backstop means that Britain is held hostage by the EU, unable to create trade agreements with other countries until the EU agrees to a trade deal with the United Kingdom. To placate the Brexiters, the deal reached by Theresa May said that the backstop would only be “temporary.” And that was not satisfactory to the Brexiters who now want a firm date as to when the backstop ends.
Given the sharp differences between UK Brexiters and the leadership of the EU, and given that the Parliament rejected a path toward extension of Brexit, it appears increasingly likely that a no-deal Brexit could take place. To avoid this, someone will have to blink. It is not clear who that will be. Of course, a no-deal Brexit might be avoided. Britain could choose to abide by the deal Prime Minister May reached (unlikely) or something similar, it could postpone Brexit, or it could choose to have another referendum. Yet in the absence an alternative, a no-deal Brexit grows likelier by the day. Thus, it is worth considering what a no-deal Brexit would entail.54
On trade, Britain’s exit from the EU would ultimately mean that World Trade Organization (WTO) tariff rates would go into effect. For most products, WTO tariffs would not be terribly high, but there are exceptions. The two-way tariff on automobiles would go up to 10 percent, which could be quite onerous considering the degree to which the United Kingdom and continental automotive industries are integrated. In time, it would likely mean that much automotive assembly in the United Kingdom would shift to the continent. However, in order for the United Kingdom to be subject to WTO tariffs and rule, it must provide a schedule of services and goods that have yet to be approved by the 163 members of the WTO.55 In addition, the British Parliament would have to pass several hundred laws to enable the UK to trade under WTO rules. These processes will take time, of which there is not much left. Without entry into the WTO, much higher tariffs could emerge, raising prices for UK citizens and creating substantial disruption.
Beyond tariffs, there could be disruption to trade involving slower processing of traded goods at major ports. For example, at the Port of Dover, 2.6 million trucks (lorries) entered the United Kingdom from the EU in 2017. Customs officials are not yet equipped to process such a large volume, despite nascent efforts to prepare. Thus, delays are a near certainty. Indeed, British retailers have warned of shortages of fresh foods.56 In addition, there will be a change in the regulatory environment. Goods crossing the border will have to be checked for conformity to regulations on food safety, environmental safety, etc. This, too, will take time and, in the early days of Brexit, could create substantial delays and confusion.
One sticky issue is the fact that the United Kingdom has agreed that it owes money to the EU.57 However, in the event of a no-deal Brexit, it is possible that the United Kingdom would simply not make the payment. In the fiscal year for 2019–20, the United Kingdom and EU have agreed that the payment is meant to be EUR16.5 billion. Over the longer term, the amount is perhaps EUR40 billion. If the United Kingdom fails to make a payment, then individual countries of the EU would have to foot the bill. At the least, this could worsen relations between the two sides and make it more politically challenging to agree on future deals.
Perhaps the biggest sticking point is the Irish border. Indeed, it can be argued that this issue alone contributed the most to the failure of Theresa May’s deal with the EU to pass in the Parliament. Her effort to avoid a hard border between Ireland and Northern Ireland offended those Brexiters who saw this as a backdoor retention of EU membership. Yet others worry that if a hard border is created, the conditions for armed conflict between the two sides could reemerge. A no-deal Brexit would mean customs controls at the border.
There are several million EU citizens living in the United Kingdom and vice versa. A no-deal Brexit wouldn’t necessarily require people to move. However, there are questions about the rights of these people. For example, under EU membership, pension benefits from one country can be received in another. It is not clear if this would be true under a no-deal Brexit.
The worsening state of the Chinese economy is a source of concern for businesses and governments around the world. China’s economy has become so large that it is an engine of growth for other countries, especially in Asia and also in the United States and Europe. In the past decade, the increase in China’s GDP, when measured in US dollars, matched the increase of both the United States and Europe combined.58 Thus, although China’s economy remains smaller than that of either the United States or Europe, its impact on global growth has been massive, especially given the large volume of goods and services that China imports. And, with Chinese growth decelerating, the impact on the global economy could be significant. Meanwhile, European Central Bank (ECB) President Draghi said that he is confident that the stimulus measures introduced by the Chinese government will help to ease the decline in European growth.59 China is a big importer of capital goods from Europe, especially Germany, and the slowdown in demand in China is already having a negative impact on European growth. China’s stimulus has involved easing of monetary policy and increased fiscal spending.
With respect to fiscal policy, China is accelerating efforts to stimulate its economy. Since December, the National Development and Reform Commission (NDRC) has approved 16 infrastructure projects with a total value of RMB1.1 trillion, or US$163 billion.60 This represents a 10-fold increase in the volume of infrastructure projects initiated compared to the 12 months prior to December. The vice chairman of the NDRC said, “China will speed up investment projects and local government bond issuance, but will not resort to ‘flood-like’ stimulus.” This comes amidst a sharp slowdown in fixed asset investment. However, the scale of the stimulus that has been approved remains relatively modest compared to what was done at the time of the global financial crisis 10 years ago. At that time, China initiated a stimulus worth RMB4 trillion, 38 percent of which involved infrastructure. Moreover, the current stimulus will, in part, be funded by the issuance of new bonds by local governments, thus adding to the burgeoning debt that has already alarmed many analysts.
Aside from attempting to boost investment, the NDRC is also intent on stimulating consumer spending that has lately been weak. It announced that it will ease restrictions on the market for second-hand automobiles.61 The government sees the automotive market as key to increasing consumer spending. It has noted that, although China has the largest automotive market in the world by far, the number of cars owned per capita remains far below the levels seen in the United States, Europe, and Japan. A top official at the NDRC said, “There is still potential for automobile consumption, and it can even be said to be relatively large.” All of these efforts come at a time when Chinese officials are worried that, in the absence of a new trade agreement with the United States, China could face increased tariffs and a worsening economic situation. Thus, it is intent on stimulating domestic demand.
The US Federal Reserve is shifting gears, just weeks after indicating an intention to continue on the path of interest rate normalization.62 In December, the Fed suggested that there could be two interest rate increases in 2019. Now it says it intends to put rate hikes on hold. This stunning reversal in attitude surprised—and pleased—investors. Bond yields fell, equity prices rose, and the value of the US dollar fell. Fed Chairman Jay Powell said, “The case for raising rates has weakened somewhat. We believe we can best support the economy by being patient in evaluating the outlook before making any future adjustment to policy.” The shift in policy was supported unanimously by the Federal Open Market Committee (popularly known as the FOMC).
Not only did the Fed stop raising interest rates, it also said that it is willing to adjust its balance sheet policy. Up until now, it has been reducing the size of its balance sheet by not rolling over bonds as they mature. This “quantitative tightening” likely contributed to the elevation of bond yields. Yet yields have lately declined sharply as investors downwardly revised their expectations of inflation in the face of weaker economic prospects. The Fed’s statement indicated that it was responding to “global economic and financial developments and muted inflation pressures.” Powell pointed to weaker growth in Europe and China, trade tensions, and tightened financial market conditions. The reversal in Fed policy could reduce the likelihood of a recession in the next year or two.
The latest employment reports from the US government indicate that the temporary government shutdown in January did not dampen job growth. Indeed, the job market remains strong and tight. The US government issues two reports; one is based on a survey of establishments, the other on a survey of households.
The establishment survey revealed that 304,000 new jobs were created in January,63 the strongest increase in 11 months and far in excess of what is needed to absorb new entrants into the labor force. It was also far more than investors had anticipated.64 Interestingly, equity prices in the United States barely responded to the news, moving very little. This suggests that the euphoria over a strong economy was dampened by increased fears that the Federal Reserve will change its mind again and tighten monetary policy. In any event, by industry there was strong growth in construction, retailing, transportation, healthcare, and leisure and hospitality. Our own industry of professional business services, however, had only modest job growth—perhaps reflecting a shortage of skilled labor. In addition, manufacturing employment also grew surprisingly modestly. Also, wages continued to accelerate, with average hourly earnings rising 3.2 percent from a year earlier, the fastest rate of growth in a decade. This reflects the tightness of the job market and bodes well for continued increases in consumer spending. The separate household survey saw the unemployment rate rise from 3.9 percent in December to 4.0 percent in January,65 in part due to the impact of the temporary government shutdown.
Finally, despite the very strong job market, there are other reasons to be concerned about the US economy. Indices of housing market activity have fallen, consumer confidence has dropped, trade has taken a hit, and credit market conditions have weakened. Job market numbers tend to be a lagging, rather than a leading, indicator of overall economic activity. Thus, the Fed’s decision to stop tightening monetary policy can be seen as reasonable, despite the tightness of the job market. However, if the job market remains tight and contributes to an acceleration of wage inflation in the months ahead, and if the trade war does not worsen, then the Fed may decide to renew interest rate increases.
IHS Markit has released its monthly purchasing managers’ indices (PMIs) for multiple countries.66 The PMI is a forward-looking indicator meant to signal the direction of activity in the manufacturing sector that, in turn, has a big effect on the broader economy. The PMI is made up of sub-indices, such as output, new orders, export orders, employment, input and output pricing, inventories, pipelines, and sentiment. A reading above 50.0 indicates growing activity; the higher the number, the faster the growth—and vice versa. The latest PMIs suggest that the global manufacturing industry has weakened considerably. The global PMI fell for the ninth consecutive month, hitting a 29-month low and a level indicating almost no growth in activity. The sub-indices for output and new orders indicated slower growth, while the sub-index for exports indicated that exports are declining at an accelerating pace. That suggests that the trade wars are taking a toll on the manufacturing industry. The PMIs for China, Europe, and Japan all fell, with the Chinese PMI hitting a three-year low and contributing the most to the global weakness. Among large economies, only the United States bucked the trend, with its PMI rising. Here are the details:
In the United States, the PMI increased to a level reflecting strong growth in activity. This was despite a near stalling in export activity. Instead, domestic demand drove the improvement. Output and employment were up strongly, and sentiment was positive. At the same time, new orders grew at the second-slowest pace since August, and some purchasing managers expressed concern about the impact of trade policy. Meanwhile, Canada’s PMI fell to a 25-month low and a level indicating moderate growth. Output and new orders decelerated while exports were “particularly subdued.” In Mexico, the PMI rose above 50.0 for the first time in three months, largely due to a strengthening of new orders and a rise in employment. At the same time, sentiment dropped to a record low. And in Brazil, the PMI rose slightly to a 10-month high, even as the government reported that industrial production fell in December versus a year earlier.67 Brazil’s PMI benefitted from strong domestic demand even as, like elsewhere, exports performed poorly.
In the United Kingdom, the PMI fell sharply to the second-lowest level in two and a half years, hitting a level consistent with modest growth. Overall output rose modestly, but with production of capital goods falling. Much of the increase in output was destined for inventory accumulation. This may have been in anticipation of a disruptive Brexit. New orders grew slowly and export orders stopped growing.
In the Eurozone, the PMI fell to a 50-month low and a level indicating almost no increase in activity. Output of consumer goods was solid while output of capital goods was exceptionally weak. New orders were weak and export orders fell sharply. By country, Germany’s PMI fell to a 50-month low, while that of Italy fell to a 68-month low. Both countries saw a decline in activity. France, in contrast, saw modest growth, while Spain saw moderate growth. There was strong growth in the Netherlands.
Among the temporary factors that suppressed the Eurozone’s PMI were disruptive changes in automotive regulations and the so-called “yellow vest” protest movement in France. Yet trade concerns and weakness in China and elsewhere are creating more sustained problems for Europe’s manufacturers. Of particular concern is the fact that inventories are accumulating at the fastest pace on record, auguring a cutback in production in the months ahead. The surprising speed at which Eurozone economic conditions have deteriorated will likely lead the ECB to maintain an easy monetary policy.
In Asia, India bucked the global trend, with a rise in the PMI to a level reflecting moderate growth. Strong domestic demand propelled output and new orders. Even exports continued to rise. In China, however, the PMI continued to fall into deeper negative territory, hitting a level not seen in three years. Output and new orders fell as domestic demand weakened. Interestingly, export orders grew, rising at the fastest pace in almost a year. This may reflect foreigners making purchases in order to avoid potential increases in tariffs. Indeed, the direction the industry heads in the months ahead will be very much influenced by whether and how the current trade dispute is resolved.
Meanwhile, the weakness in China is having a big negative impact on other countries that are tightly linked to China through global supply chains. Taiwan’s PMI fell to a 40-month low, with export orders falling at the steepest pace since mid-2015. And South Korea’s PMI fell at the fastest pace in 26 months. Not only did export orders fall for the sixth consecutive month, but domestic conditions worsened as well. Finally, Japan’s PMI fell to a 29-month low, hitting a level indicating almost no growth in activity. New orders fell and export orders dropped at the fastest rate in 30 months. Orders for semiconductors were especially weak, boding poorly for the global technology industry. Meanwhile, domestic demand weakened, raising questions as to whether the government will want to follow through on plans to raise the national sales tax this year.