Europe
This week, European Central Bank (ECB) chief Mario Draghi expressed a positive, confident outlook on the health of the European economy during a well delivered speech to the European Parliament on Monday.
In his address he outlined ECB plans to hold the benchmark refinancing rate at 0.0%, with the first-rate hike pencilled in for Summer 2019. The central bank also plans to half the current monthly Quantitative Easing (QE) bond buying programme, taking it from €30bn to €15bn of monthly purchases. This reduction takes place in the final quarter of 2018 with the intention of bringing the programme to end. At its conclusion the ECB will have purchased €2.3trn of bonds and Mario Draghi will also complete his Presidency; he leaves at the end of the year. Draghi reflected on what he believes has been a successful albeit unconventional programme. He suggests that the stimulus effect equates to a 1.9% boost to growth and inflation between 2016-2020.
It’s important to remind ourselves of the purpose behind using these monetary tools. The ECB’s ‘zero’ refinancing rate is the rate of interest the central bank charges European banks to acquire funds for lending on to business and individuals. By making funds available at no cost it incentivises banks to lend, and in turn helps support spending and investment in the economy. Central bank bond purchasing is different in its transmission. This is where central banks buy bonds from the market to increase the money supply (liquidity). This pushes down long-term borrowing costs and encourages risk taking by investors. The bond buying measures usually follows on from interest rate adjustments, especially in extreme scenarios because it adds more downward pressure onto borrowing costs.
The extreme scenario of course is the 2008 financial crisis. This led us into an extreme period of ultra-low interest rates and lax monetary policy relative to history. The ECB are now very aware of the consequences of inflation and they treat the tools they use with respect. Anyone following the ECB will note how they aim to prevent market hysteria by not shouting too loud or moving too fast.
From a market perspective the announcement bringing ZIRP (Zero Interest Rate Policy) to an end and calling time on buying bonds is a clear signal from the ECB they are confident that the intensive monetary stimulus programme has worked. Draghi described the policy as being “very effective”.
The chart below shows just how economic performance is broadly correlated with the 2015 QE intervention. In mid-2017 we can see how bond purchasing decreased when it became evident Europe was making a recovery.
ECB Bond Repurchases vs European Economic Growth
Source: Bloomberg, data as of July 2018
It may seem strange to set out an intention to raise rates in the face of potential trade wars (which we write about below). However, when growth is set sustainably this is exactly the time to start raising rates to prevent the economy overheating later and causing inflation to rise.
In the short term, inflation picking up moderately can be positive because in this case it reflects growth across the whole of the economy. Inflation is currently at 1.9% (CPI), up from 1.6% in May, but remains under control and slightly below the ECB’s target of 2%.
The ECB are not cutting the apron strings entirely. Whilst they are confident the economy is ready for monetary tightening they are cognisant of the risks involved. The financial system has very much been supported by the ECB’s actions for some time now and cynics fear that by taking the stabilisers off, the economy may fall over. They are aware of this and it explains their cautious attitude and actions; introducing tapering rather than stopping bond purchases straight away and signalling well in advance their intentions to raise interest rates by what is a very small amount.
Trump
Six months have now passed since President Donald Trump launched his first salvo in an attempt to reduce America’s growing trade deficit as illustrated in the chart below. We know that each new tariff announcement is designed to up the ante. By design it is part of a much larger plan to tackle what Trump perceives as the unfair competition US firms face abroad.
Trade Deficit
Source: Bloomberg, data as of July 2018
Thus far, there have been ‘tit-for-tat’ exchanges between the US and China, and more recently between the US and Europe. This is a typical, disruptive tactic in Trump’s mission to achieve more favourable terms for America.
This week, US Trade Representatives announced further tariffs of 10% on $200bn of Chinese products. How China will respond is not yet known. The obvious retaliation would be to implement further tariffs on goods imported from the US (they matched duties on $34bn of goods imposed by the US last week). However, China will struggle to match the new increased tariffs slapped on it this week. Its imports from the US last year only amounted to $154Bn! This is deliberately provocative.
What tactics can China play?
A blanket tariff on all goods imported from the US; this would be a bold move as they cannot source some of the goods elsewhere.
Non-tariffs retaliation:
• Make it more difficult for US companies to do business in China
• Currency management, targeting a weaker Renminbi to make Chinese exports cheaper
• Foreign Exchange reserve mix – hold fewer US Dollars
• Use alternative currencies such as Euros and Sterling to trade at the expense of US Dollars
Predicting the next strategic steps of this trade tariff debacle is not easy. We know further escalation will begin to have greater ramifications both economically and politically. Meanwhile, the trade tariffs have failed to materially disrupt economies, but if Trump puts forward another $500bn of tariffs, as he has alluded to, this could be problematic for economies. It may begin to weigh even more heavily on stock market performance and consumer sentiment.
The lessons from history around imposing high tariffs is that while they lower the incentive for imports (a benefit for the US domestic economy given its net-import status) they also push up costs. If this pushes down on growth we end up with an economic scenario referred to as stagflation.
Many say that if further tariffs end up wiping out the benefits the US is enjoying from the recent fiscal stimulus then Trump’s tactics will have failed. However, the US economy does at least have this stimulus effect to cushion them. It appears that no one really knows if the tax cuts occurring along-side the decision to start a trade war is inspired genius or just coincidental. Whatever the real intent it is certainly helpful to Trump to have a stimulus effect in place right now as these negotiations continue.
Whilst Trump has primarily been targeting China, America’s largest trading partner, he has also had one eye on Europe. After tariffs were placed on imports of European steel and aluminium into the US, Europe’s strategic response was not only to place tariffs on US consumer goods but to target those which have a strong symbolic, political impact.
Tariffs were placed on Harley-Davidson motorcycles and cranberries which are produced in Wisconsin (the state of Paul Ryan, speaker of the House of Representatives) and on Bourbon whiskey produced in Kentucky, home of the Senate Majority leader Mitch McConnell. This targeting of specific goods produced in politically sensitive constituencies is a tactic that may also appeal to China. It is a particularly smart political counter move as the US begins its run-up to mid-term elections in November. With international trade secretaries taking a very strategic approach to negotiations, the current “tit for tat” exchanges are beginning to resemble less a game of Top Trumps, than one of Grandmaster chess.
One thing is sure, we should expect more headlines as Trump struts the international stage culminating in a meeting with Russian President Vladimir Putin on Monday.
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