US-Chinese tension makes for a fascinating time in history

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Donald Trump’s tweets on May 5 fueled tension between China and the US, dramatically triggering renewed speculation on the conditions of any fresh trade deal. China retaliated to fresh US border tariffs on its goods by applying taxes to US imports. This move interrupts a long period of calm that had kicked off after the G20 meeting on December 1 (see my blog post dated February 21 2019 here)

Donald Trump’s drive to apply fresh tariffs on China reflects his determination to bring jobs back to the US – especially in the manufacturing sector – and also ease the country’s dependence on China. 
The country had a $419bn trade deficit with China in 2018 due to hefty imports of goods into the US, while conversely American companies struggled to export sufficiently to China. The chart above makes for a perfect illustration of this tricky situation for the US.
The situation recently became a lot more challenging, as the flipside of this Chinese trade surplus with the US was its financing for the US economy via US Treasuries purchases in particular. This set-up worked for a long time and it acted as a way for the two countries to remain tied together, as Chinese goods found a market in the US while China financed the US economy to make up for Americans’ insufficient savings. The US-Chinese relationship was based on a complementary approach, but this balance is shifting as China’s contribution to financing of the US economy has been decreasing over the past several months. In March 2019, the proportion of US financial assets held by China as part of the United States’ total external financing returned to lows witnessed in June 2006. 
The balance between the two countries is changing and the US can no longer have the same influence on China that it had in the past. China is standing apart and wants to achieve greater independence.

The White House is also running out of patience with China taking its time to meet its requests. By taxing Chinese imports, Washington is seeking to dent economic activity in the country, and there is a danger that this will generate severe social tension and force the Chinese government’s hand, as it did not want to take this social risk. Sluggish Chinese economic indicators since the start of the year could lend credence to Washington’s approach, and prompt it to take an even harder line on trade, yet this approach is not necessarily the right one. 

At the beginning of 2019, the weight of the United States in Chinese exports slowed down considerably. Chinese dependence on the US is reversing, while at the same time, the Chinese are relaunching the “Belt and Road Initiative” whose objective is to further diversify the Chinese market. China is expanding its markets and is effectively limiting the influence of the United States on its economy.

The other major disagreement between Washington and Beijing is on technology, andin my view, this is the main bone of contention between the two countries. China’s technology has caught up very swiftly over the past twenty years via technology transfers and by setting aside substantial resources to facilitate this fast progress. This approach worked well, and China now has some headway over the US, particularly in 5G and artificial intelligence. 
The United States’ loss of technological supremacy is a radical change as China has the resources to develop these technologies without US support. This kind of situation could have emerged with Japan a few years ago, but Japan always remained within the US sphere of influence… the same cannot be said of China. The country has a huge domestic market, while development outside the country is vast, so this can now generate self-sustaining technological momentum. 

Washington has been particularly tense on this issue over recent months, with sanctions against ZTE in April 2018, and in particular against Huawei in December 2018 attesting to this strain. European governments have also come under pressure to steer clear of Chinese technology (read here). More recently, Donald Trump blacklisted Huawei (read here – behind paywall), while other Chinese companies no longer have access to the US market such as China Mobile (read here – article in French).

The stakes are very straightforward – the country that decides the standards for these new technologies will gain a massive competitive advantage and be able to more easily develop innovations using these technologies. This is the stumbling block for negotiations as China has invested substantial resources to notch up this technological advantage and does not want to be dictated to by the US. Similarly, it seems unthinkable that the US would spontaneously accept China’s progress and be dictated to by the country in order to use its technologies. 

This technological battle of wills will not be resolved by itself. Neither country is set to give in, so an agreement looks unlikely, unless the Chinese economy takes a severe downturn, but this is not part of our scenario.
However, it does not stop there. Development of 5G for example is at the heart of a number of innovations and countries outside China and the US are developing businesses that use this technology. This means that developing these innovations on a mass scale will probably require use of Chinese technology, and this is set to trigger more tension with the US. Emmanuel Macron has already made his position clear on this issue (see statement at the Vivatech event here). 

The dynamics of the world economy are changing, but the new world order is not going to emerge straight away. This is the first time in history we have seen this kind of situation, and the first time that the world economy could shift towards a new region as a result of technological innovation. When the center of gravity of the world economy shifted from the UK to the US, there was still a degree of continuity, but the same cannot be said of today’s situation. And Europe will also have to find its place in this new order. 
This transformation will overturn the dynamics of the world economy and change the entire balance between the various regions of the world. 
What a fascinating time to observe world events.

GDP, Employment and Productivity in the Euro Area

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Employment increased in the euro area during the first quarter (+ 1.4% annualized). The pace of job creations is solid. However, since the beginning of 2018, productivity has lost momentum and it doesn’t improve. GDP is not growing fast enough in the face of rising employment.
The risk is that an external shock from, for example, global trade will penalize activity with after that a quick adjustment on employment. The economy does not create leeway (no productivity gains) that may cushion negative shocks. That’s worrisome.

Business investment profile is still worrisome

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The pace of capital goods orders in Germany in March suggests a further slowdown in investment in OECD countries over the coming months.
Orders are down 5.9% year-on-year and this indicator is closely correlated with the investment profile of OECD countries.

This slowdown in orders is global.
The rebound in the Euro zone is limited since over a year the decline in orders is still -6.5%. The rest of the world does not look encouraging either.

This is why I have doubts on the investment profile published by INSEE yesterday for the manufacturing sector for France. A 11% growth is expected for 2019 after 0% in 2018. This seems excessive since the survey shows a rapid slowdown in the second half. This means that the first semester has to be very strong. This is not necessarily consistent with what we see in the pace of investment of non-financial companies in the first quarter.
The survey is probably a bit too optimistic. Capital goods orders continue to contract in April 2019. I do not imagine strong investments in France while the rest of the world is rather in an investment slowdown.

French growth fails to accelerate in the first quarter despite measures on purchasing power

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French GDP growth decelerated slightly in the first quarter of 2019 even though the rounded figure stands at 0.3% (non-annualized) as in the previous two quarters. Despite the stimulus measures announced at the end of 2018, growth has not been boosted by the increase in households purchasing power.
Achieving the government target at 1.4% for 2019 on average would require growth of 0.43% in each of the remaining three quarters. It’s ambitious.

The annual change in activity is 1.1% in the first quarter, well below the trend observed since the 2013 recovery at 1.4%.
After the acceleration of 2017, resulting from the very buoyant global environment, the growth of the French economy can not deviate from the figure of its potential growth estimated generally between 1.2 and 1.3%.
For the moment, the measures implemented by the government are not able to go beyond this and this is worrying in a context where the sharp rise in the price of gasoline is a threat to the purchasing power that would penalize consumers’ demand.

Contributions to quarterly GDP growth are easy to remember. Domestic demand contributed 0.3%, inventories increased GDP by 0.3%, while net exports slowed growth with a contribution of -0.3%.

The important point is the slight acceleration of household consumption whose contribution goes from 0 in Q4 2018 to 0.2% in the first quarter. This is barely above the average observed since the recovery (0.15%) while government measures explicitly targeted consumption.
Government spending is growing at a slower pace, and this is the same for investment, whose contribution is decreasing marginally, notably because of the contraction of household investment. On the corporate side, the investment is a little stronger than in the last quarter of 2018 and that’s good news. However, this remains very limited (see the graph in appendix). This is insufficient to instil a solid dynamic into the cycle of the French economy.

The bad surprise comes from foreign trade whose pace is less robust than the monthly figures suggested until February. The contribution is frankly negative even if the contribution of imports is less negative than in Q4 2018. Exports stagnate and penalize growth. The French economy is also penalized by the world trade slowdown.

The accumulation of stocks has driven growth upward. Its pace in the second quarter will depend on the dynamics of demand. If this strengthens stocks will continue to fill. On the other hand, if the demand is lower, because the price of gasoline increases a little too fast, then companies could reduce these stocks which would penalize the profile of the activity.

The French GDP will accelerate in Q1

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The French GDP for the first quarter of 2019 will be published Tuesday morning at 0730. After a figure of 0.3% (non annualized figures according to the French tradition) over the last three months of 2018, the consensus is at 0.3%.
My expectation is that 0.3% would rather be the bottom of a range between 0.3 and 0.5%.
During the first three months of the year, there was a clear improvement in industrial production (+ 1.2% carryover for Q1 at the end of February against -0.4% in the last quarter of 2018). There is also a recovery in the pace of the business climate survey. In the last quarter of 2018, this index fell by 2.1 points compared to the previous quarter, whereas it stabilized over the first three months of the year.
It should also be noted that household consumption is slightly positive when it contracted in the last quarter of 2018. Finally, foreign trade could have a neutral impact, with exports (in value) growing a little faster than imports but Given the deficit, the contribution will be close to neutrality.
The big unknown is about business investment. Capital goods orders are shrinking rapidly, suggesting a lower capital expenditure despite the stabilization of business surveys.
Looking at the industrial production and surveys, GDP is expected to pick up slightly in Q1 at 0.4%. If business investment is less dynamic than expected then it will converge to 0.3%. If all goes well (the services sector momentum is improving in the INSEE survey, if the investment is more robust than expected and consumption accelerates in March) then the figure of 0.5% could be reached.