There are two themes that are driving both the global economy and markets. The first is a threat of a trade war and the second is US monetary policy.
The US President, Donald Trump, has threatened a 10% tariff on a $200 billion list of Chinese imports. Donald Trump said he was acting because China had outlined tariffs on $30 billion worth of US products. China is, in fact, responding to the US’ original aluminium and steel tariffs, which were announced earlier in the year.
The additional tariffs would follow a US Government public consultation process, which could take at least three months. Donald Trump has also condemned China’s “unfair practices related to the acquisition of American intellectual property and technology”.
In the short term, the material effect of a trade war will be small, since the tariffs come against a strong economic backdrop. The Chinese reaction is also likely to be measured; after all, they recognise that Donald Trump is partly playing to his voter base, ahead of the mid-term elections in November.
The US and its traditional allies, the European Union, Canada and Mexico, are also on the brink of a full-scale trade war. Originally, these allies were granted a temporary reprieve from the US implementing the tariffs on the aluminium and steel imports. The US said there had been insufficient progress in talks with all three countries to reduce America’s trade deficit, and that the waiver was being lifted. Donald Trump has again delivered the message to the world that ‘America First’ is a reality even if it comes at the expense of traditional trading partners.
US Monetary Policy
The US, as always, leads the way with monetary policy. The US Federal Reserve (Fed), in June, raised interest rates by 0.25%, which means that the federal funds rate is in a range between 1.75% and 2%. The Fed’s median projection for the total number of rate rises this year has also been increased from 3 to 4 times, which means a further 2 rises, by December.
The Fed’s approach to monetary policy is back to “business as usual”. The Fed acknowledged the strength of the US economy, with inflation close to target and a healthy labour market. The Fed has also removed, from its statement, the paragraph urging caution.
The Fed has pledged to continue selling back to the private markets, loans it bought as part of the $4.5 trillion Quantitative Easing (QE) programme.
The US economy is continuing to expand, with the Fed forecasting that the US economy will grow by 2.8% in 2019, whilst unemployment will fall to 3.6%.
In May, US inflation, as measured by the Consumer Price Index (CPI), rose 2.8%, on an annual basis. This was the biggest annual gain since February 2012 and reflects the strengthening oil price. The faster pace of inflation may influence the pace of interest rate increases.
UK Economy and Monetary Policy
Economic figures for the UK continue to indicate that economic growth is slowing down. In April, UK manufacturing output was down 1.4%, as demand for British goods fell, particularly steel and electrical machinery. Economists had forecast growth of 0.3%.
In May, UK inflation, as measured by CPI, rose 2.4%, on an annual basis, which is unchanged from April. Although inflation remains above the Bank of England’s 2% inflation target, UK wage growth remains above inflation, rising 2.8%, in the three months to April. Although wages have declined from 2.9% in the three months to March, the Bank of England expects wage growth to rise.
In the 3 months to April, UK unemployment remained at 4.2%, which is unchanged from the previous month and the lowest level since 1975.
Given the mixed signals on the economy, the Monetary Policy Committee is expected to keep interest rates unchanged for the time being.
Eurozone Economy and Monetary Policy
In the first three months of the year, the Gross Domestic Product for the Eurozone grew 0.4%. This is the lowest rate since the third quarter of 2016 and confirms that similar to the UK there has been some economic weakness.
The Fed was not the only central bank that announced their monetary policy. The European Central Bank (ECB) also announced that its key base rate would remain unchanged, at 0%. The ECB also confirmed that its €2.4 trillion QE policy would be tapered until the end of the year and then stopped.
Japanese Monetary Policy
The Bank of Japan (BoJ) has announced its monetary policy, leaving its key short-term interest rate unchanged, at -0.1%. The BoJ also kept its 10 year government bond yield target around 0%, but lowered its assessment on inflation, to be in a range of 0.5% to 1%, for the 2018 fiscal year.
US Dollar and Emerging Markets
The strengthening US economy, which has resulted in an increasing interest rate differential between the US and the other major developed economies, has led to the US Dollar strengthening. Although it is true that emerging markets are less dependent on the US Dollar than previously, a significant number of emerging market economies are still dependent on US Dollar denominated debt and it will impact their exports to the US.
The strength of the US Dollar has not helped the recent economic problems in Argentina or Turkey. However, the Fed Chairman, Jerome Powell, has said that the power of US interest rates is often exaggerated. If the Fed pursues an interest rate policy that puts ‘America First’ without any consideration for the emerging markets, it could hurt the global economy and consequently markets.
Donald Trump and the North Korean President, Kim Jong-un, have signed an historic pact, with the aim of working towards the denuclearisation of the Korean Peninsula, in exchange for an end to US military exercises in the region. Although the agreement is short on details, it should benefit the region’s economy.
Although the global economy is continuing to expand, which is benefiting corporate earnings, the two big issues are a possible trade war and US interest rates.
Although a trade war is not in anyone’s interest, it is feasible, however, at this stage, the market believes that Donald Trump is playing politics, before the mid-term elections.
Finally, higher US interest rates have meant that the interest rate differential between the US and the other major developed economies has widened. This should result in the US Dollar remaining strong and a key factor for both the global economy and markets over the short to medium term.