US-Chinese tension makes for a fascinating time in history

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 herebehind paywall), while other Chinese companies no longer have access to the US market such as China Mobile (read herearticle 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.

Reversal of the US labor market ?

The labor market indicator in the Conference Board household survey changed trend in March. It is always easy to find a job but the indicator is now on the downside.
Given the strong link with JOLTS labor market indicator, one may wonder about a possible reversal of the US labor market.
This is a signal that seems relevant to me (see here for longer data and more in-depth analysis).

The Federal Reserve puts an end to normalization – My weekly column

The post is available in pdf format My Weekly Column – February 4

The US Federal Reserve decided to bring its monetary policy normalization to an end during its meetings on January 29 and 30, 2019.
The interest rate hike cycle had kicked off slowly in December 2015 and stepped up a pace a year later, as nine interest rate hikes pushed the Fed Funds rate up from 0.25% (upper end of range) to 2.5% in December 2018.
During last week’s press conference, the Fed Chair indicated that Fed Funds are now in the range of neutral, in response to the first question from journalists: there is no longer an accommodative or a tightening slant. Powell’s confidence in the strength of the US economy suggests that the end to normalization should not just be seen as hitting the pause button for a while.

The rate hike cycle has been long and slow-moving if we compare to the Fed’s previous series of tightening moves from 2004 for example. A comparison with this period also reveals that real interest rates on Fed funds were much higher then than they are now. The figure is currently marginally above the level witnessed at the start of the normalization process in December 2015, unlike the situation after 2004, when the economy was much more restricted, while this is not the case in the current economic situation.

A comparison of current real interest rates with previous phases of monetary tightening shows that today’s situation is completely different to these episodes.
Real interest rates in November 2018 stood at around 0.4% (inflation figures for December are not yet available on the PCE index), which is much lower than figures in 2006, 1999 or 1990. Does this mean that the US economy is too weak to be able to deal with a real rate above 1%? This would be extremely worrying and would undermine Jerome Powell’s comments that the US economy is in a good place.

It is difficult to understand why US normalization is coming to an end when we look at the economy, as unemployment is near its low, so the central bank should be tightening the reins. The Fed’s projections for 2019 and 2020 are for figures above the country’s potential growth rate and this also fits with the economists’ consensus, at least for 2019. Against this backdrop, monetary policy needs to be tighter to ensure that growth does not create imbalances that then have to be addressed, and this was the message from Powell in 2018, when he suggested that fiscal policy (too aggressive for an economy running on full employment) would need to be offset by tighter monetary policy to rebalance the policy mix. During the press conference on Wednesday January 30, he did not raise this question: the issue was side-stepped, but yet the analysis still remains the same. There are only two possible economic explanations for the halt to normalization: either there are expectations of a severe downgrade to projections when they are updated in March, but this would not be consistent with Powell’s comments; or the Fed is doing whatever it takes to extend the economic cycle at any cost, with the end to the rate hike cycle aimed at cutting back mortgage rates and taking the pressure off the real estate market. However, with the overall economy remaining robust, the risk of this type of move is that it could lead to imbalances that would be difficult to eliminate. This is the opposite approach to the Fed’s strategy right throughout 2018, so it would be a strange tactic.

ISM index dropped: a healthy adjustment.

ISM index dropped: a healthy adjustment.
In the USA, the fall of the ISM may reflect a return to a more normal situation? For many months, this indicator for the manufacturing sector was well above the CFNAI index which is a measure of 85 indicators of the economic activity (prepared by the Chicago Fed).
This situation, which has been a regular occurrence since 2004, always ends with a sharp and brutal adjustment of the ISM to the CFNAI. The adjustment always takes place in this direction. Finally, the overly optimistic expectations contained in the ISM index adjust to the “real economy” which does not present excessive optimism. This adjustment is rather healthy. 

The flattening of the yield curve and the possibility of a recession in the US.

First step the 5yr-2yr spread is now null before being negative with the Fed tightening. Then the 10yr-2yr will flatten before being negative for the same reason. This has always been a signal of recession. This time is not different and 2020 can be anticipated for it.
spread5-2-us-en.png
The two curves have the same pattern even if levels are different. They provide the same message for 2020.
spread5-2er10-2USA-en.png

US jobs and manufacturing activity My Wednesday column

This post is available in pdf format My Wedenesday Column – November 7

US job growth is buoyant, but is it all down to the Trump effect?
The US economy created 250,000 jobs in October, which is a bit higher than the average of 213,000 witnessed since the start of the year. However, October is usually a fairly good month for new job creation, with 271,000 in October 2017, and an average of 246,000 in the month of October since 2013 as compared to an average of 206,000 for other months.
The labor market is buoyant overall, reflecting a solid pace of economic growth although nothing to write home about with 2.25% per year on average since 2011.US jobs Continue reading