A surprise re-escalation of the tariff war – weekly update 13 May

Trump’s administration caught global markets by surprise

Donald Trump’s administration caught global markets by surprise in suddenly announcing a re-escalation in the US-China tariff war. Initiated, as usual with a tweet, the administration has now implemented an increase in tariffs from 10% to 25% on US$200 billion of goods imported from China, and is considering increasing the scope of goods subject to these tariffs by an additional US$300 billion.

The move came after accusations from Washington that Beijing was trying to change the deal and cast a pall over the latest trade delegation’s visit to the US. China has threatened retaliatory tariffs, but has yet to provide details. A number of big unknowns remain, which could have a significant impact on markets.

Crucially, markets will be looking for any evidence as to whether this move is simply a negotiating tactic to extract further last-minute concessions in the trade deal or whether this is a genuine reacceleration of the trade war, potentially to distract from domestic politics. Thus far, despite last week’s sell-off, markets have generally taken the moves in their stride, and indications are that the US President will meet his Chinese counterpart at the G20 meeting next month, which could provide the next pivot point.

US inflation remains soft

Core inflation measures in the US remained soft, supporting the Federal Reserve’s (Fed’s) wait-and-see stance, but we shouldn’t be too complacent. The Fed’s preferred measure of inflation, the Core Personal Consumption Expenditure (Core PCE) index, slipped from 1.7% to 1.6% year on year (yoy, the headline dipped from 1.4% to 1.3%), whilst the more familiar basket-based Core Consumer Price Index (CPI) measure picked up from 2.0% to 2.1% as expected.

In the details, some of the more cyclical areas such as apparel and autos weighed the readings down, however upward pressure remains in shelter and medical costs, which tend to be more persistent. The Fed also looks at an alternative PCE measure, the Dallas Fed’s Trimmed Mean PCE which strips out volatile elements, and Fed Chair Jerome Powell cited this index, which is running at 2.0% yoy, amongst others as reasons to believe the soft PCE readings may be transitory.

This line justifies the Fed’s current pause, but also argues against the need for a cut in rates, which the market is currently pricing in. However, if the latest developments with the US and China tariff war mark a fresh intensification, the Fed may have few options but to join the fray with fresh monetary stimulus.

Selected measures of core inflation (year on year)

US wages remain robust but fail to pick up

Sticking with the US, the monthly labour report showed wages remaining robust, but failing to pick up. Average hourly earnings grew at 3.2% yoy in April, unchanged from March and defying expectations for a pick-up to 3.3%.

The headline Non-Farm Payrolls reading saw 263,000 jobs added, comfortably ahead of the 190,000 expected. Unemployment fell 0.2% to 3.6%, the lowest level since the late 1960s, though much of the recent move can be explained by a fall in participation rate, down 0.2% to 62.8%. Sometimes this can be a sign of workers simply becoming discouraged and leaving the system.

UK first-quarter GDP

Closer to home in the UK, the first estimate of first-quarter GDP suggested a pick-up to 1.8% yoy (from 1.4%) but there are risks of distortion. The consumer continued to prop up the core economy, but there was also a pick-up in business investment during the quarter, which helped the annual rate pick-up from -2.5% to -1.4% (a deterioration to -2.7% was expected).

However, a common theme of late is that much of this is thought to be down to Brexit-related stockpiling, as we’ve highlighted over the last month or so, and also a factor in the most recent Industrial Production figure which surged from 0.4% to 1.3% yoy (0.5% was expected).

We also saw the Bank of England put out a surprisingly hawkish inflation report, and the Governor, Mark Carney, explicitly warned in his press conference that there could be a need for interest rates to increase “more frequent[ly] than financial markets currently expect”. Whilst the Bank’s forecasts are based on an orderly Brexit outcome which is far from certain, it is often a brave investor that ignores such a blunt warning from the Central bank.

Last week’s other events

• Eurozone first-quarter GDP growth beat expectations with 1.2% yoy (from 1.1%, no change expected). Unemployment ticked down 0.1% to 7.7% (no change was expected) and core inflation picked up from 0.8% to 1.2% (1.0% expected)
• US PMI readings from the Institute for Supply Management (ISM) disappointed with the ISM Manufacturing PMI falling from 55.3 to 52.8 (55.0 was expected) and Non-Manufacturing PMI falling from 56.1 to 55.5 (an increase to 57.0 was expected). Elsewhere, we saw Personal Income fall from 0.2% to 0.1% month on month (mom), versus expectations for an increase to 0.4%, whilst Personal Spending fell from 0.3% to 0.1% (0.3% was expected)
• In China, the official Composite PMI slipped from 54.0 to 53.4, with disappointments in both the manufacturing and non-manufacturing components. The private Caixin measure also had a disappointing manufacturing reading (50.2 from 50.8, 50.9 was expected), but services picked up from 54.4 to 54.5 (54.2 was forecast)
• In the UK, the composite PMI reading picked up from 50.0 to 50.9 (50.6 expected) with an expected dip in Manufacturing PMI from 55.1 to 53.1 offset by a bounce in Services PMI from 48.9 to 50.4 (50.3 was expected)

The markets

Ahead of the bank holiday weekend markets were relatively unperturbed, but came back from the break to the surprise re-ignition of the US-China trade spat, with the predictable risk-off response.

One-month performance of major asset classes in sterling terms

Equities

After trading fairly flat in the first week, equity markets fell in the wake of the renewed trade tensions. Japanese equities were the worst performing market of those we cover, falling -4.1%, and faring even worse than the Emerging Markets index, which fell -3.7%. Europe (Excluding the UK) fell -2.9% and UK equities were off -2.7%. The US proved to be relatively resilient, but still fell -1.9% over the fortnight.

Bonds

10-year US Treasury yields fell -3 basis points (bps) to 2.47%. The equivalent German bund yields were also down -3 bps to -0.05% whilst the equivalent UK government bond yields were unchanged overall at 1.14% after making a broader round-trip. This perhaps highlights how tight core sovereign fixed income markets already are.

Commodities

Gold was bid up amidst the turmoil, but still finished below the US$1,300 mark, closing on Friday at US$1,286 per ounce. Oil was softer at US$70.62 per barrel (Brent Crude) by the end of the week and copper fell to US$2.79 per lb.

Currencies

The Japanese yen picked up the main risk-off currency flows, whilst the US dollar was broadly weaker over the fortnight. Sterling closed on Friday at US$1.30, €1.16 and ¥143.

The week ahead

It’s a more subdued week this week, though there are still a few releases that could be of interest. In particular UK labour market data on Tuesday, the latest China data batch (including Industrial Production, Retail Sales, and Fixed Asset Investment) on Wednesday morning, and US Retail Sales on Wednesday afternoon (0.2% mom in April expected from 1.6% based on the advance group). The daily breakdown is as follows:

Monday: It’s a quiet start to the week, with only the leading and coincident economic indicators from Japan of note.

Tuesday: Early in the morning, Japan reports Bank Lending activity and the Eco Watchers survey of economic activity. Later in the morning, the UK reports on the labour market where forecasts are for Average Weekly Earnings growth of 3.4% yoy (from 3.5%) and unemployment unchanged at 3.9%. Also in the morning, Eurozone Industrial Production is reported (-0.8% from -0.3% yoy expected) and the latest ZEW economic sentiment survey results. The US will also report Small Business Optimism from NFIB and the latest import and export price data.

Wednesday: We start with the batch data from China – Fixed Asset Investment is expected at 6.4% from 6.3%, Industrial Production is forecast as unchanged at 6.5% and Retail Sales are expected at 8.4% from 8.3% (all on a year-to-date, yoy basis). The afternoon sees US Retail Sales as the main focus (see above).

Thursday: Another fairly quiet day, with Japanese PPI inflation and Housing Starts in the US the only data of note.

Friday: Eurozone construction output is reported in the morning, whilst in the afternoon the latest sentiment surveys from the University of Michigan will be released.