Trade breakthrough

Trade breakthrough  |  Jackson Hole  |  Distorted recession signal

Produced by RBC Global Asset Management's Chief Economist Eric Lascellesthe for #MacroMemo for the week of August 27 - August 31, 2018

 

Trade developments:

• US-Mexico breakthrough:
  • After weeks of palpable progress and mounting expectations, the U.S. and Mexico have announced a deal on key NAFTA issues translating mainly into a greater reliance on North American auto parts (75% minimum from a 62.5% minimum). The arrangement is also said to encourage more use of North American industrial goods such as steel. Reports are still hazy, but the much-feared five-year sunset clause demanded by the U.S. may have been watered down into a six-year review mechanism, followed by a subsequent ten year sunset if no agreement was reached after six years. On the subject of dispute resolution mechanisms, some sectors would continue to receive full access to these tools, while others would have only limited access. Curiously, the steel and aluminum tariffs recently applied by the U.S. will not be removed just yet.
  • This tentative deal is very positive news in that it indicates the U.S. is actually serious about striking new trade agreements and also because increases the prospect of a new comprehensive NAFTA agreement. The Mexican peso is up today, and has gained roughly 10% since the middle of June.
  • However, the U.S. and Mexico are not quite done, in part because life would be much simpler (and their economies stronger) if Canada is included in any new pact, in part because Canada may not fully agree to the new proposals (or to any Canada-specific demands made by the U.S. such as concerning the dairy sector), and in part because ultimately U.S. Congress must approve the deal.
  • As we have discussed before, this now puts Canada in the hot seat. The White House will attempt to cajole Canada into hastily signing onto the U.S.-Mexican deal under the threat of being excluded altogether. To this effect, President Trump has already proposed renaming NAFTA the United States-Mexico Free Trade Agreement. Chief negotiator Lighthizer has indicated he’d like Canada to sign onto the deal by the end of this week – what would appear to be an unreasonable timeline given that the U.S. and Mexico just spent many weeks in negotiations. True, some of the new items may already be settled to Canada’s satisfaction. But other aspects of the new deal may be unacceptable to Canada, resulting in significant work needed. As a means of applying pressure, the U.S. is now threatening an auto tariff on Canada.
  • Our base-case scenario remains that Canada will ultimately be included in any new deal. The country will likely have to make some concessions – perhaps lowering barriers for the dairy sector and being more flexible about sunset clauses and dispute resolution mechanisms – but can more likely than not find a way to get a deal done.
  • We now assign a 60% chance of a new NAFTA deal (though split between a 15% chance of the U.S. “winning” via additional embedded protectionism versus a 45% chance of a more mixed compromise deal), against a 15% chance of the trade zone being torn apart, and a 25% chance that the existing NAFTA ultimately survives. If this last scenario seems odd given recent progress, recall that ultimately the U.S. Congress must approve any new deal. One conceivable sub-scenario involves Canada being excluded and Congress refusing to ratify a bilateral deal. Another sub-scenario involves Canadian negotiations taking sufficiently long that a vote doesn’t occur until 2019 when a new (and likely Democrat-led) Congress is much less favorably disposed toward a Trump trade win, regardless of the specifics.

• U.S.-China trade axis:
  • In sharp contrast to recent forward progress on NAFTA, the U.S.-China relationship continues to slip. Both countries pounded one another last week with tariffs on a further $16B of imported goods and the Chinese trade delegation did not achieve anything of note.
  • We budget for a further deterioration between the two countries, with tariffs on another $200B in Chinese products now more likely than not.
• Protectionism base case:
  • Pitting improving NAFTA prospects against deteriorating U.S.-China odds, the China deterioration proves more consequential given that the world’s two largest economies are intertwined. In turn, our base-case trade scenario has shifted from a “slightly negative” outcome to a “negative” one. This subtracts a few additional tenths of a percentage point from GDP growth for the U.S., China and the world. Of course, from a Canadian or Mexican perspective, the situation is looking somewhat better.
• Tariff duration: the hidden dimension
  • For all of the focus on the size of tariffs, remarkably little intellectual capital has been dedicated to how long these tariffs might last. The duration of a tariff is no less relevant than the size in determining the total economic damage (see next characteristics).
  • It is not possible to speak with precision, but for the most part we expect U.S. tariffs to last for multiple quarters to multiple years. True, a few small items such as steel and aluminum tariffs on Mexico and Canada might be removed fairly quickly. But the China relationship will likely take some time to resolve given little visible progress so far. All the same, we do not believe these new tariffs are permanent. Whether they are ultimately unwound for reasons of economic expediency, because they are deemed illegal either nationally or internationally, or because another president will eventually occupy the White House, one way or another these tariffs will eventually go away.

Jackson Hole recap:

• With regard to the immediate outlook for U.S. monetary policy, Fed Chair Powell was 100% aligned with the prior FOMC statement, going so far as to quote it: “As the most recent FOMC statement indicates, if the strong growth in income and jobs continues, further gradual increases in the target range for the federal funds rate will likely be appropriate.” Our best guess is that the Fed remains on a quarterly tightening path, with rate increases in September and December likely.
• However, a number of other dovish messages emerged from Powell’s speech:
  • Inflation was acknowledged to be near 2%, but with “no clear sign of an acceleration” and with no sense that the economy is at an elevated risk of overheating.
  • “Risk factors abroad” were cited – presumably a nod toward slowing Chinese economic growth and recent flare-ups in Turkey and a handful of other places.
  • More fundamental to the future conduct of monetary policy (but, strictly speaking, not a new revelation) was Powell’s reiteration that he prefers to take a reactive rather than proactive approach to monetary policy. Yes, this means the Fed will occasionally be behind the curve, but it reduces their reliance on forecasts that have so often been proven wrong in the past. In short, they only want to be raising rates when they can see economic strength, rather than when it is merely predicted.
• Further dovishness came from two other sources at the Jackson Hole confab.
• First, Bank of Canada Governor Poloz took up the popular argument that innovation and productivity growth are being under-measured, with the indirect implication that monetary tightening does not need to be quite as aggressive. We are not convinced this has any short-term implication for Canadian monetary policy, but it helps to tilt the balance toward no hike in September (though still further tightening later in the fall).
• Second, the focus of the conference was the rising concentration of market share at the sector level. The conventional wisdom is that this increases corporate profit margins but slows economic growth via less innovation by complacent companies with big moats around them. There was certainly some research supporting these views, but interestingly other academics argued that these conclusions are not yet airtight, noting that productivity gains may be undercounted, big new tech firms tend to be quite innovative and are natural monopolies, and some of the traditional sectors seeing increased market concentration are not actually reducing consumer choice (for example, regional grocers are merging across the country – this results in fewer grocery chains on an absolute basis, but not necessarily any fewer grocery brands jostling with one another in any single market). We tend to take something of a middle ground: yes, there probably is a bit less innovation happening due to more concentrated sectors, but not as much as one would imagine looking at the raw figures.

Yield curve less worrying than it looks:

• We are regularly on the record arguing that the U.S. business cycle is at a fairly late stage. This is still probably true.
• An increasingly flat and flattening yield curve (classically, the spread between short-dated and long-dated bonds) makes this argument more persuasively than most, at least on the surface.
• It has been widely reported that the U.S. 2-year to 10-year spread has collapsed to just 20 basis points, down from several hundred just a few years ago. If the trend continues, this curve will invert in fairly short order – famously interpreted to mean a recession is on the way.
• As it happens, this imminent recession signal is probably exaggerated.
• First, the 3m-10yr spread has historically done a better job of predicting recessions than the 2yr-10yr spread. The 3m-10yr spread is still about a percent away from inverting.
• Second, the fact that longer dated bonds no longer enjoy a term premium argues – theoretically, at least – that the curve would need to invert substantially before the signal of old is genuinely achieved on a term premium-adjusted basis (note, however, that contrary to theory a recent San Francisco Fed paper argues that the term premium isn’t a relevant consideration in practice).
• Third, research from the Federal Reserve in Washington DC argues that the one-quarter to six-quarter ahead 3-month T-bill spread is actually the best for predicting recessions. As the following chart illustrates, this spread has actually widened somewhat recently and is still a considerable distance from inversion, suggesting near-term recession risks are overblown.
• Ultimately, we are still quite comfortable with our multi-faceted assessment that the U.S. economy is at a fairly late stage of the cycle. But the 2-10 yield curve input is probably providing an exaggerated claim.

 

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