Macro Weekly – The blessing of the US midterm elections

by: Han de Jong

  • US midterm election results positive for economy and financial markets
  • Asian trade picks up, Germany still in the doldrums
  • Steady Fed set for December hike
181109-Macro-Weekly.pdf (241 KB)

The Democrats have gained a majority in the US House of Representatives at the midterm elections. At the time of writing, they have won 225 seats against 197 for the Republicans with 12 seats yet to be declared. As far as the Senate is concerned, with three seats yet to be decided, the Republicans will maintain their majority, now holding 51 against 44 for the Democrats and 2 independents who usually align with the Democrats.

I think that is the best result financial markets could have hoped for. This result does two important things. The Democrats’ majority in the House is by no means overwhelming. That reduces the chance they will start impeachment proceedings against the president. That is good for financial markets, because such proceedings would lead to a lot of unexpected twists and turns and create huge uncertainty, which is unpleasant for financial markets.

Having read Luke Harding’s book ‘Collusion’ at the beginning of the year, I considered impeachment of the president a distinct possibility. But having recently read Bob Woodward’s ‘Fear’, it now looks unlikely to me. The Woodward book suggests there simply isn’t a strong legal case against the president. The fact that the Democrats’ majority in the House is small, suggests there is decent support for the president. Should the Democrats start impeachment proceedings they run the risk of not all Democrats in the House supporting the impeachment which would make them look silly. Even if the House impeaches the president, the Senate decides over removal from office and the evidence against the president simply does not look strong enough to persuade a sufficient number of Republicans to vote their own president out of office. The Democrats then run the risk of delivering Trump a huge sympathy vote at the next presidential elections. So my guess is that there will not be impeachment proceedings.

At the same time, the Democrats’ majority in the House reduces the president’s room for manoeuvre, particularly on budgetary issues. That means that Trump will be unable to provide another significant stimulus to the economy should he wish to do that. The tax reform, tax cuts and planned spending increases which have been implemented by the Trump government so far have come at a time when the US economy was doing well and did not need additional stimulus. As such, these measures have raised the risk of overheating and of accelerating inflation.

The somewhat higher risk of accelerating inflation has forced the Fed to be a little more restrictive than they otherwise might have been. A new fiscal stimulus would raise the risks further. But now that the Democrats control the House, they are not going to let Trump do it again. So my take here is that the result of the midterm elections reduces the risk of the Fed being forced to tighten policy more than expected. That is positive for financial markets. It was not surprising therefore that US equity markets were up 2% on the day after the elections.

The problem with US monetary policy for financial markets

There is a big problem for financial markets related to US monetary policy. The Federal Reserve conducts monetary policy focussing on the US economy. Obviously! As US growth is strong and inflation is trending higher Fed policy is getting tighter. Unfortunately, the rest of the world economy is not half as strong as the US. So US monetary policy is inappropriate for the rest of the world. That really would not matter but given the US’ leading role in the world economy and, more crucially, the importance of US interest rates for global financial markets that creates a big problem. Rising US interest rates have the potential to destabilise financial markets around the world when they are vulnerable. But the fact that the midterm elections reduce the risk of ill-timed fiscal stimulus in the US also reduces the risk of further destabilisation of even higher US interest rates.

Steady Fed

The November FOMC brought no surprises. Anybody expecting the Fed to become more dovish in view of financial market volatility may have been disappointed, but the Fed was never going to stray from its pre-set path very easily. Given the recent criticism of president Trump, the Fed had no choice but to maintain its position that gradual further tightening is appropriate, while trying to be as inconspicuous as possible. A December rate hike is to be expected.

The November FOMC was the last one without press conference, allowing the Fed to keep its head down. There was, nevertheless, one small but not irrelevant change in the statement. The previous statement had said that ‘business investment has continued to grow strongly’. The most recent statement said that ‘growth of business investment has moderated from its rapid pace earlier in the year’. This, of course, is just acknowledging what the data shows. However, the Fed cannot be sure how far they will have to raise rates to prevent the economy from overheating while also preventing to hike so much that the economy is pushed into a recession. Acknowledging that growth in this particular area of activity is moderating can be a first sign that the end of the tightening cycle is getting closer. We see no reason to change our view that the Fed will hike three more times between now and mid 2019 and then stop. The Fed itself is saying it will hike five more times this cycle with the last projected hike occurring in 2020. The market appears to be pricing in two to three more hikes this cycle.

Strong trade data in Asia

Regular readers know that I focus a lot on Asian trade flows as a way of taking the pulse of world trade. Data released in recent days was strong. Taiwan’s exports were up 7.3% yoy in October. Taiwanese yoy export growth started the year near the 15% mark, but fell in the course of the year. It reached a low of only 2% in August, so the acceleration to 7.3% is good news. The pulse of trade in Asia is ticking a little faster. Also, bear in mind that Taiwan is an important player in the electronics industry. The strengthening of Taiwan’s export growth suggests the global tech sector is not faltering.

Chinese trade data for October was also robust. Imports were up 21.4% yoy (USD terms), up from 14.5% in September. Chinese exports were up 15.6% yoy, versus 14.4% in September. I think the import numbers are particularly impressive. Imports from the US (ca 6% of total Chinese imports) have weakened lately. In October, the dollar value of this flow was actually down 1.8% yoy. Given all the tariffs that are flying around, it is hard to say whether the recent strong data is distorted and provides a flattering picture of what is really going on. But so far, so good. Stay tuned.

Europe still in the doldrums

There was not much in the line of European macro data in recent days. German factory orders were up 0.3% mom in September after a plus of 2.5% in August (originally reported as 2.0%). Nevertheless, the yoy rate was -2.2%, worse than August’s -1.8%. Industrial production was up 0.2% mom, after +0.1% in August (originally reported as -0.3%). The yoy rate improved from +0.2% (originally reported as -0.1%) to 0.8%. One can look at this data from two angles. In absolute terms, the data is soft, very soft. Bear in mind that German industrial production was rising at a yoy rate of over 6% around the turn of the year. On the other hand, the September data was a touch better than the August data and we have to also must remember, as I wrote about last week, that car production had been extremely depressed in August and September. The October data on car production has meanwhile been published and is looking better (not great, mind you, but better, a lot better than the -27% for August and September on average: +6.9% yoy). So between the improved data on Asian trade and the improvement of car production, I would expect data on industrial activity in Germany to improve in the period ahead. That would be helpful. The recent trade data in Germany is still pointing lower. Export values were down 0.8% mom in September. That was the sixth month this year out of the nine for which we have data with a minus sign for the mom change.

French data on industrial activity are equally poor, if not poorer. Manufacturing output contracted by 2.1% mom in September, pushing the yoy rate to -1.0%, down from +1.8% in August. France also has a significant car industry (though much smaller than Germany’s) and may be plagued by the same challenges as the German car industry.