Monthly Macro Outlook: Waiting for Godot – Waiting for fiscal push

It was a very eventful month of August again. The United States labeled China as “a currency manipulator”, opening a one-year-round of negotiations before the implementation of new US sanctions. And, once again, central banks rescued financial markets by confirming they have launched a new easing cycle. Volatility increased quite sharply, reaching almost its highest level since the beginning of the year and, without much surprise, investors were looking for safe heaven, notably gold (for more on that point, read Ole Hansen’s excellent analysis). On the macroeconomic front, we had confirmation that there will be no rebound in growth and trade in H2, as we have repeatedly stated, and that the risk of recession is clearly increasing.

China: New signs of stabilisation

Compared to the previous month, the macroeconomic outlook in China has not changed much. There are new signs of stabilisation of the economy popping up here and there, but domestic demand remains weak and headwinds from global trade developments continue to hurt the economy. Our leading indicator of the Chinese economy, credit impulse, which tracks the flow of new credit as % of the economy, is still in contraction at minus 3.8% of GDP. It reflects the impact of the liquidity crunch onshore and regulatory measures taken by the PBOC that especially affect small banks. Most of China’s output indicators are also down, especially electricity generation (-2.7% YoY in July), excepted for the volume of rail freight that is still well-oriented (9.1% YoY in July). For obvious reasons, we don’t expect that the recent improvement in the manufacturing sector will last. New exports orders slightly increased in July, at 46.9, but from a very low level. The dynamics is still negative for small and medium sized enterprises. The bulk of the improvement is related to large-sized companies that can find countermeasures against tariffs and have large market shares aboard.

Since the beginning of the month, despite China’s attempts to reduce depreciation, the RMB has decreased by 2.8% versus the USD, which is already bigger than the August 2015 devaluation. Further dilution of the RMB is likely in coming months, reflecting mostly risks to China’s GDP growth, trade war friction and lower rates. The technical analysis tends to confirm this scenario: at the beginning of the month, the USD/RMB has broken its 50-day moving average and it has been evolving above its 200-day moving average since last May. Contrary to what happened in 1990s, the risk of contagion to other Asian currencies is rather limited. Into 1997, Asian countries were facing lower foreign reserves and elevated current account deficit, which is not the case anymore. What is more likely is to see some downward pressure on Asian equities in case of further depreciation of the RMB.

On a more positive note, China’s total fixed asset investment growth has been broadly stable in recent months, as state investment offset lower private investment. The same substitution effect has already occurred in the past in period of low growth. However, investment in infrastructure is still disappointing, running at only 3.5% YoY, which means the likelihood of new measures to stimulate infrastructures will probably be announced very soon.

Rest of the world: Risks of technical recession are increasing

In the rest of the world, the outlook is deteriorating in many countries. All the major economic regions (world, developed markets and emerging markets) have a Markit PMI close or below 50 and not a single G7 economic has a PMI above 51. There are currently nine major economies in recession or on the verge of it: Argentina, Brazil, Germany, Italy, Mexico, Russia, Singapore, South Korea and the United Kingdom. For some of them, it is due to bad policies but, for others, it is directly linked to the recent evolution of global trade. Many analysts have been too quick to blame trade war for the negative macroeconomic impact. We are not trying to downplay this factor but, in our view, China’s slowdown and China importing less from the rest of the world are more important drivers of lower global trade and recession risk. If we look at countries that are likely to face a technical recession this year _ Germany, South Korea and Singapore_ they all high a very high exposure to China.

What is different now from a few months ago is that the negative impact of China’s slowdown is not contained to the manufacturing sector anymore. We see in many countries, especially Germany, a contagion of weakness from manufacturing to services. The latest German PMI Services was out a solid 54.4 in August but lower from its highest annual point of 55.8. The gap observed between the manufacturing sector and the service sector is doomed to be reduced in coming months, with the service sector going down, unless governments decide to implement demand-oriented stimulus.

All eyes on central banks in September

Looking ahead, we all know that the main market focus will be on central bank meetings in September. We don’t expect any positive outcome from ongoing US-Chinese trade talks which should increase pressures on central banks to support the economy.

Jackson Hole Symposium meeting was the awaited confirmation by investors that central banks are ready to step in again, but no one is fooled about the expected impact of a new round of measures on the real economy. Long-term and short-term interest rates are low, they can go a little bit lower, but it will not drastically change financial conditions that are already very accommodative. On the top of that, if QE was able to push inflation back to the target, we would already know it. We are again in a new extend-and-pretend phase. However, this time, it might be different as governments seem to be ready for fiscal push in order to avoid recession. Debates about 2020 budget will be interesting in coming weeks as we could see fiscal policy taking the lead again.

In the interim, we expect central banks will try to reassure investors by announcing further rate cuts. In the space of only a few weeks, the Federal Reserve has given up mention of “mid-cycle adjustments”. Evidence are compelling that we are not mid-cycle, but rather at the end of the cycle. Being trade war dependent, the evolution of the US monetary policy will be highly dependent on trade war developments in coming months. We think the current deadline of September 1^st, when the US administration is expected to implement new tariffs against China, has already been priced in by the Fed. Adding to that the positive outlook for the US economy delivered by J. Powell at Jackson Hole, we expect that the Fed will cut rates by 25 bps in September but the likelihood of another 25 bps cut by the end of the year is very high.

Finally, the ECB should unveil “a significant and impactful policy package in September” (Oli Rehn). The official reason is to counter doubts over ability to revive inflation, but the real primary reason is the risk of recession in Germany. We think that the ECB will try to formalize the new medium-long term monetary policy path before Lagarde’s step in after October confirmation. We think the ECB could lower by 20 bps the deposit rate and restart the QE by 30bn euros per month. A tiering system, which has been often mentioned, is out of the new policy toolkit for now as “some concerns were raised regarding possible unintended consequences” according to the latest ECB minutes.