Global Daily – Are downside risks easing?

by: Nick Kounis , Bill Diviney

Global Macro: Trade truce and dovish shifts important, but skew of risks still downwards – There are two significant positive developments over recent weeks. First of all, there are some signs of light at the end of the tunnel on the trade policy front. The chances of an escalation in the trade war between the US and China have clearly diminished. The latest confirmation of this was comments from President Trump saying that there had been ‘substantial progress’ in trade talks and that he had decided therefore to delay the increase in tariffs scheduled for 1 March (the rate on USD 200bn of China’s imports was set to go up from 10% to 25%). The talks will be extended with the hope of a deal at some point in the future. Meanwhile, UK parliamentarians could put pressure on the government to negotiate an extension to the Article 50 deadline with the EU this week (see below for more).

Central banks have changed their tune – The second key development has been the noticeable dovish shift by central banks. The Federal Reserve and the BoE have signalled that further policy rate hikes for this year are being put on the shelf, while the ECB will soon very likely do the same. The US central bank has also made it clear that it will end the run-down of its balance sheet by the end of the year, while the ECB appears set to launch new programme of long-term loans to banks over the coming months. Furthermore, some Fed officials have started to float the idea that they would be tolerant of an inflation overshoot as a way to re-anchor inflation expectations. Even though this is part of a longer-term discussion of the Fed’s policy framework, it has tended to re-inforce the impression of a dovish shift. Finally, the Chinese authorities have started to ease fiscal and monetary policy over the last few months. These steps have arrested the tightening of financial conditions and we have seen some easing over recent weeks.

Trade uncertainty lower but not removed – Despite these positives, our sense is that the balance of risks remains skewed to the downside, and that these developments may take some time to feed through into firmer activity data. First of all, uncertainty related to trade policy remains elevated. It remains to be seen if the US and China eventually make a deal (even though it is looking more likely) while there are reports that the US is still mulling tariffs on car imports on the back of a confidential US Commerce Department report. At the same time, an extension of the Article 50 deadline for the UK’s exit from the EU may not substantially reduce uncertainty unless it is a relatively long one.

Taking foot off the brakes – Second, although central banks have certainly seen a dovish shift, it is not (yet at least) a significant enough move to be a strong tailwind for the global economy over the coming quarters. We still characterise the situation as being one of policymakers taking their foot off the breaks rather than stepping on the gas. These moves will also take time to feed through, so the global economy is likely to remain weak in the near term, with macro and earnings downgrades still in the pipeline. We expect the global economy to regain some traction later in the year, but the improvement is likely to be gradual and moderate. The shift in the stance of monetary policy is not sufficient to trigger the kind of rebound that we saw in 2016-17.

Italy and political risks still loom – Finally, other risks are not dissipating. Financial markets reacted positively to the decision of Fitch to keep Italy’s BBB rating (two notches above junk) with a negative outlook. There had been a fear of a downgrade. However the headwinds are for sure not behind Italy. The recession is deepening and the fiscal measures the government is taking are expensive. We expect a major budget deficit over-shoot relative to the target of the authorities. This could lead to renewed clashes with the European Commission. European political risk could also be fuelled by a string of upcoming elections this year (see here). (Nick Kounis)

UK Politics: Not whether to delay Brexit, but by how much – The UK parliament will once again vote on a set of Brexit-related amendments this coming Wednesday, but given the proximity now to the 29 March Article 50 deadline, this vote will be particularly crucial. Parliament has been surprisingly timid in seizing control of the Brexit process – despite having the power to do so, and despite the government’s haphazard handling of Brexit. At this stage, there are two key amendments that could pass – one by Conservative backbenchers requesting a ‘strictly time limited’ extension to the Article 50 deadline, and a more ambitious cross-party proposal to request a delay with no timescale specified at this stage. We believe the latter is both more likely to pass, and the more favourable outcome in terms of reducing no-deal probability, as it opens the door to a much longer extension (perhaps 21 months, as is being discussed on the EU side to Bloomberg) than the 2-3 month extensions that have been floated by some MPs.

A short extension would be problematic, as it would likely mean the UK not participating in the May European elections, which would then make it legally impossible for the UK to extend further and to remain in the EU after the opening of the new European Parliament on 1 July. The only way to avoid a disorderly Brexit in that scenario would be for the UK to formally leave the EU and to enter directly into a transition arrangement similar to that envisaged in May’s deal. This could well take a People’s Vote/Remain scenario off the table, and hamper what little negotiating leverage the UK has left. This would make (a variant of) May’s deal the more likely end-game scenario, but by virtue of it being the least-worst option. In contrast, a longer extension would make a second referendum much more likely. In either case, we continue to think parliament will avoid no deal, either by ultimately passing a version of May’s deal, or by putting the question back to the people in a new referendum. (Bill Diviney)