Renewed Threat of Trade War Makes Investors Anxious

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  • The resignation of Gary Cohn has sent ripples through the capital markets
  • Australia’s Q4 growth was a little slower than expected and China reported a drop in its reserves
  • Today’s North American session features the Bank of Canada meeting
  • In addition to US trade figures, the ADP private sector jobs estimate will be published
  • Bank Negara kept rates steady at 3.25%, as expected; Turkey central bank kept all rates steady, as expected

The dollar is mixed against the majors in the wake of Cohn’s resignation. The yen and Swissie are outperforming, while Loonie and Stockie are underperforming. EM currencies are mixed also. THB and KRW are outperforming, while ZAR and MXN are underperforming. MSCI Asia Pacific was down 0.5%, with the Nikkei falling 0.8%. MSCI EM is down 0.6% on the day, with the Shanghai Composite falling 0.6%. Euro Stoxx 600 is down 0.4% near midday, while futures are pointing to a lower open for US markets. The 10-year US yield is down 4 bp at 2.85%. Commodity prices are mostly lower, with oil down 0.8%, copper down 0.5%, and gold down 0.1%.

The resignation of Gary Cohn, one of the few “globalist” advisers in the US Administration, has sent ripples through the capital markets. Stocks have been marked down across the world. The prospects of a trade war are also not good for growth and it may be adding to the pressure on yields.

Cohn’s resignation has two immediate consequences. As Cohn goes, so does the last-ditch effort of forces within the Administration seeking to deter the tariffs. Treasury Secretary Mnuchin seems more supportive, though probably would have preferred a more targeted approach. The industry summit Cohn was trying to arrange has been canceled. That means that Congress is the next potential check on the unilateral trade power of the executive, which has largely been transferred from the legislative branch.

Second, we suspect that investors are also responding to the implications for future trade policy. It means that the Ross and Navarro wing will set the tone. This signals a more confrontational and aggressive trade policy. The US reports the January trade balance today and it provides grist for their mill. The US is expected to report a $55 bln trade shortfall. The January 2017 deficit was $48.7 bln and in 2016 is was $43.4 bln.

This illustrates the broad deterioration, even though we know that there has been dramatic improvement in the energy trade balance.   Floating exchange rates and free-trade, they argue, should not result in the US have a significant and chronic trade deficit unless 1) exchange rates are not really floating and/or 2) trade is not fair.

However, the response to the US actions arguably are the key to whether it turns into tit-for-tat spiral. This is surely one scenario, but is it the most likely? First, we think about precedent. What was the response to Bush’s 30% tariff on steel? There were more exemptions then, including Canada and Mexico, and there was some protective action so that the sales were not simply deflected to a third party (e.g., Europe), and there were some symbolic gestures, and ultimately WTO challenges.

Second, we think through the strategic values. By some measures, many high income and developing countries manage their trade and economies more than the US. However, there is a general acceptance of the multilateral free-trading system, and nearly all countries are members of the WTO. If the multilateral system is being challenged, it is incumbent on the other members to reinforce it. In this case, it means there may be some symbolic action, like on whiskey from Kentucky, but the best course is to challenge at the WTO. Some fear that if the case were to be decided against the US (may not for a year or more), the current administration would leave the WTO. It is possible, but unlikely. It would likely require Congressional approval, which would not be forthcoming.

The MSCI Asia Pacific Index fell almost 0.6%, while the Dow Jones Stoxx 600 is off 0.4% in Europe. The S&P 500 futures contract is off a little more than 0.5%. Yields on ten-year benchmark yields are off mostly 2-4 bp. Of note, despite jitters at the start of the week, and not much more insight into what the next government will look like, Italian assets are not underperforming. The 10-year yield is off three basis points today and is now slightly lower since the election. The FTSE/Milan is flat today and is the only major European bourse still higher on the year.

There have been two economic reports to note today. Australia’s Q4 growth was a little slower than expected and China reported a drop in its reserves. Recent data warned that softer capex and weaker net exports was a drag on Australia’s growth at the end of last year. Today, Australia reported quarterly growth of 0.4% after a revised 0.7% pace in Q3 (initially 0.6%). The y/y pace slowed to 2.4% from 2.9%. The Reserve Bank of Australia is expected to be on hold for most of the year, if not into the next.

China reported a larger than expected $27 bln draw down in the value of its reserves in February. The last time China’s reserves fell was in January 2017. We suspect that while there were likely private capital outflows, the main drivers are innocuous. These include distortions from the Lunar New Year as well as some impact from valuation. The euro, likely the second largest currency in the PBOC reserves, fell 1.8%. If 20% of China’s reserves are in euro-denominated assets, the euro’s decline alone would explain an $11 bln fall in China’s reserves. Of course, China’s reserves are held in some financial instruments. Yields rose in February. Lower bond prices could also impact valuation.

Reports suggest the US is considering limits on Chinese investment in the US and tariffs on a broad range of Chinese products in response to China’s policies on intellectual policy. Chinese officials have expressed a desire to avoid a trade war, but press reports suggest they are studying retaliatory tariffs on US products such as soybeans. The situation is fluid, but recent developments suggest a more confrontational approach to trade by the US ahead.

Today’s North American session features the Bank of Canada meeting. The Bank of Canada is widely expected to stand fast after hiking rates at the start of the year. The probability of a rate cut has been trimmed but it is near 40% for April and more than 50% by May. Although Canada’s largest trading partner the US is enjoying above trend growth, and is providing additional fiscal support, the positive impulses are offset by the protectionist actions, steel, aluminum, and risks that NAFTA dissolves. The Canadian dollar has depreciated by nearly 5.5% on a trade-weighted basis since the end of January.   Earlier in the week, we recommended looking Canada to soon outperform Mexico. A potentially important upside reversal (for Canada) appears to have taken place yesterday.

In addition to trade figures, the ADP private sector jobs estimate will be published. The market expects around a 200k increase after 234k in January. The Beige Book is out late in the session as is January consumer credit. Neither is typically a market-mover. The Fed’s Bostic and Dudley speak early in the session.

There is a large $1.7 bln option struck at JPY105.50 that expires in NY today. Between $1.3875 and $1.3900, there are about GBP800 mln in options that will also be cut today. There is also a large option in the New Zealand dollar (NZD760 mln) struck at $0.7300 that expires. The euro, yen, and Swiss franc are firm. Large external surpluses in Sweden and Norway have not protected the Scandies, which are the weakest majors after the Canadian dollar.

Bank Negara kept rates steady at 3.25%, as expected. CPI rose 2.7% y/y in January. While the bank does not have an explicit inflation target, lower price pressures should allow it to hike very cautiously after it started the tightening cycle in January. Next policy meeting is May 10. With elections to be held by August, we think policymakers will not tighten ahead of that.

Turkey central bank kept all rates steady, as expected. CPI rose 10.3% y/y in February. While this is the lowest rate since July, it remains well above the 3-7% target range. Core inflation remains even higher at 11.9% y/y in February. What’s worse, PPI inflation picked up to 13.7% y/y from 12.1% in January and suggests upside risks for CPI ahead. Next policy meeting is April 25. If CPI inflation does accelerate, it will get harder and harder for the bank to remain on hold.