June 2018 Economic Update

Royston Capital Economic Update

June edition 2018, By Chris Boag

June 2018 is shaping up to be pivotal month in both global economics and geopolitical issues. Trump has brought North Korea to the negotiating table, and while global economic growth is softening post 2017 highs we are seeing two major central banks continue to unwind QE and increase interest rates. A broadening trade war remains a risk to global growth but we are yet to see any real escalation in the skirmish between the US and China. Geopolitical tension has eased this month and it drew me back to a comment from the September 2017 Market Update where I noted:

“A key risk to the global economy is that of the rising tension between the US and North Korea. As Gideon Rachman of the Financial Times said in his AFR article, Miscalculation could lead to a Korean war, 5 Sept 2017 “These risks would be difficult to manage even with rational, experienced leaders in power. But the key decision makers are a 71-year-old businessman with a volcanic temper and no relevant experience, and a 33-year-old dictator, surrounded by frightened sycophants.”

In recent days Trump and Jung-Un have proven they are a match. Trump has seemingly done what 3 previous US presidents have failed to do and that is to get North Korea to stop its nuclear program (in theory). Trump had to make some interesting concessions. Only time will tell if this will lead to real progress and peace. There are still other geopolitical issues, but none looked as worrisome as this.

December 2017 / January 2018 Market Update
Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran – throwing the Middle East into chaos – and protectionism against China.

In the US Federal Reserve Officials unanimously raised interest rates for the second time this year and upgraded their forecast to four increases in 2018. The “Dot Plot” showed eight Fed policy makers expect four or more quarter point rate increases this year. The median estimate implies a further three rate increases in 2019 to put US interest rates in the neutral setting neither stimulating or restraining the economy.

The US economy is doing very well. The course of U.S. interest-rate hikes remains gradual, and the slightly more aggressive pace shows officials see more urgency to tighten policy. Unemployment already fell in May to the level they had forecast for year-end. U.S. growth is also getting a boost from $1.5 trillion in tax cuts and a $300 billion increase in federal spending, with inflation at the central bank’s 2 percent target for two months. The Fed has signalled confidence about the strength of the U.S. economy as the beneficial impact of continued labour market gains is reinforced by a pickup in business investment and higher government spending.

Today (June 14) the European Central Bank meets to discuss its policy settings.  The ECB is seeking to continue its path of exiting its QE program and as such will need to paint a positive picture for the euro-zone economy. This is despite growth having moderated. This slowing in the pace of European economic growth is not expected to persist, but together with some moderation in European inflation it is strengthening the position of the “doves” at the European Central Bank (including President Mario Draghi) who want to see very easy monetary policy maintained until at least the end of September. Easy monetary conditions plus the continuing edging down in unemployment in Europe still make it likely the European economic growth will rebound through the summer months and possibly quite strongly.  It is plausible that rather than end its asset purchase program in September, the ECB will extend it for at least three months and keep open the possibility of further extensions. This, in turn, would push back expectations for the beginning of the rate-hiking cycle.

As the US Fed and the ECB express confidence about the economic outlook, the two central banks will also be reaffirming a policy shift that has been apparent for a few months: their move away from the practice of countering spikes in volatility in financial markets.

December 2017 / January 2018 Market Update
Italian Election Troubles: Markets are fully pricing in the sanguine scenario of “much ado about nothing”. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM?

As for Italy, the market has got it right. Let’s face it, the government on average changes at least once a year.

In China GDP growth held at about 6.8% year on year proving to be the exception to the rule for global growth, although it is increasingly looking shaky. Economic readings continue to imply robust economic growth, but they also indicate that the rebalancing of growth drivers towards retail spending is difficult to achieve. The Chinese authorities would like households to spend more and save less however it would seem a poor welfare safety net encourages high savings rates. This is further exacerbated if pension funds are facing solvency issues. The Authorities continue to reform credit, and this is having a flow on effect in emerging markets (along with an appreciating USD$). Brazil is showing some signs of stress.

December 2017 / January 2018 Market Update
Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked.

In Australia the Reserve Bank (RBA) has held rates steady yet again. Australian GDP is going against the trend and is improving, not moderating. Growth is maintaining pace at around 3.1% and Australia is starting to grow faster than the United States and has an employment growth record over the past five years that on a population adjusted basis is much stronger. These comparisons of economic performance in Australia and the United States would seem to indicate that it cannot be too much longer before the RBA starts to lift the official cash rate. The main factors holding the RBA back from starting to hike the cash rate is a still benign inflation outlook, low growth in wages and high household debt. The economy is becoming capacity constrained which will lead to wages growth, inflation and a rate increase.

Overall, we now have reduced geo-political risks and solid global economic growth. The risk of a trade war escalating is real and could derail the global economy, Australia would be in the direct firing line if the US and China cannot resolve their trade differences. For now, we will wait and see what kind of deal Trump can make.

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Sources: Alexander Funds Management; BCA Research; Bloomberg; Mohamed El-Erain; AFR 14 June 2018 “US economy is great again, Federal reserve chair Jay Powell says”, John Kehoe.