Spiralling or negotiating? Trade wars, Brexit and global economic uncertainty

Another relatively quiet data week on the Australian front, with second quarter readings on construction work done (down quite sharply) and private capital expenditure (also down but accompanied by a relatively decent outlook for next year). Next week will be much busier, with the RBA Board meeting on 3 September followed the next day by the release of Q2 GDP.

The global economic narrative has once again been dominated by trade policy volatility, with last weekend’s tit-for-tat tariff rises and President Trump’s call for US firms to ‘start looking for an alternative to China’ followed by more emollient words earlier this week. The odds of a no-deal Brexit rose again with news that the UK PM intends to suspend parliament (an interesting approach to restoring the sovereignty of the mother of parliaments).

This week’s readings cover Australia’s balance of payments, the state of the housing market, corporate purpose, and the ‘Japanification’ of the world economy.

What I’ve been following in Australia . . .

The ABS reported that construction work done in the June quarter of this year fell by 3.8 per cent (seasonally adjusted) over the quarter. That was quite a bit weaker than market expectations, which had picked a more modest one per cent decline. The sharp quarterly drop saw the pace of annual decline in construction exceed 11 per cent. Within that total, residential construction was down quite steeply, falling 5.1 per cent over the quarter and 9.6 per cent over the year. So, although indicators of housing market activity (prices, auction clearance rates) have been showing signs of stabilisation for the past couple of months now, dwelling investment continues to suffer, and will serve as a headwind for next week’s Q2 GDP reading – and beyond.

The ABS also released data on private new capital expenditure (capex) and expected expenditure this week. The numbers showed new capex in the second quarter falling by 0.5 per cent (seasonally adjusted) over the quarter and down by one per cent over the year. That was a bit worse than market expectations of a modest 0.4 per cent quarterly increase and followed on from a (larger) fall in the previous quarter. The overall numbers were dragged down by a 3.3 per cent quarterly drop in spending on buildings and structures, in line with the construction work results noted above. On the other hand, spending on equipment, plant and machinery was up 2.5 per cent over the same period. Moreover, the result on investment expectations was quite positive: the third estimate for total capex for 2019-20 was $113.4 billion, which was 10.7 per cent higher than the corresponding estimate for 2018-19. The same estimate was also 14.9 per cent higher than the second estimate released earlier this year. That’s a fairly reassuring signal on investment intentions, especially given the nature of the global economic backdrop. It will be interesting to see whether current investment intentions are sustained in the face of the global volatility we’ve seen over the third quarter of the year.

. . . and what I’ve been following in the global economy

As has been the case for much of this year, trade wars, Brexit, central banks and bond markets have dominated the economic headlines since the previous Weekly.

The previous week ended on a troubling note, with a further escalation in the trade war between China and the United States. Beijing announced last Friday that it would impose tariffs on up to US$75 billion of US imports including soybeans, cars and oil. The new tariffs are scheduled to take effect on 1 September and 15 December, mirroring the timetable that Washington had laid out in its previous round of new trade measures targeting Beijing. China’s move prompted an immediate US response, with President Trump saying that the United States would increase existing tariffs on US$250 billion of Chinese imports from 25 per cent to 30 per cent, and in addition that scheduled new tariffs on a further US$300 billion of Chinese imports would now be increased from 10 per cent to 15 per cent. The president also urged US businesses to rethink their China strategies, tweeting: ‘Our great American companies are hereby ordered to immediately start looking for an alternative to China, including bringing your companies HOME and making your products in the USA.’ Markets reacted negatively, worrying that the trade dispute was starting to spiral, although Trump subsequently helped restore a degree of calm early this week, when he predicted that a trade deal with Beijing was ‘coming’.

The renewed outbreak of US-China commercial hostilities took place around the same time as the world’s central bankers were meeting at the annual US Fed shindig in Jackson Hole, Wyoming. Inevitably, trade wars were on their mind, and the bankers were clearly concerned about their limited scope to deal with the consequent economic fallout. Fed Chair Jerome Powell warned that ‘Trade policy uncertainty seems to be playing a role in the global slowdown and in weak manufacturing and capital spending in the United States’ and noted that monetary policy had a limited ability to address the problem, pointing out that ‘while monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rulebook for international trade.’ His remarks did not go down well with the US President, who continues to place the Fed under intense public pressure to ease monetary policy. RBA Governor Lowe, who was attending, delivered a similar message on the limitations of monetary policy in offsetting the adverse growth consequences of the current international policy environment (see the readings below).

Trade war fears and their monetary policy implications have continued to weigh on global bond markets. The extremely low level of bond yields – including around US$16 trillion of bonds currently trading with negative nominal yields – indicates that investors see very little prospect of growth or inflation, not just in the short term, but in the medium and longer term too. At the same time, the slope of the US Treasury yield curve has once again been warning of a potential US recession over the next 12 to 18 months.1

And then there’s Brexit risk. The news that British Prime Minister Boris Johnson would suspend parliament between early September and 14 October has been widely interpreted as increasing the likelihood of a no-deal Brexit. We’ve noted a few times here in the Weekly that markets appear to have been quite complacent about the probability of what they seem to have been treating as purely a tail-risk. Increasingly, however, no-deal (or another general election) appears to be the most likely single outcome.

How to interpret all this? I think there are two – not mutually exclusive – ways of thinking about the current state of play. Unfortunately, neither is particularly optimistic.

The first approach is to see events through the prism of policy uncertainty. The tit-for-tat tariff increases and the on-again, off-again talk of a trade deal serve as a constant source of uncertainty for economic actors in the global economy. Likewise, Brexit, albeit on a smaller scale. That uncertainty in turn distorts economic decision-making and deters investment, which then undermines trade and economic growth, with feedback effects to business confidence. According to this view of the world, only a lasting resolution to the current trade wars and Brexit risk will remove the problem. How likely is such a resolution? Well, on Brexit it’s possible we’ll have a resolution of sorts by 31 October, at least if the UK PM has his way. Not that this would be the end of the matter in terms of EU-UK negotiations, which would still have a (probably bumpy) road ahead in setting the terms of the future relationship. The answer to the same question on trade wars depends in part on how we read the recent history of the conflict. Are we now witnessing the risk of trade measures and retaliatory measures spiralling out of control? Or is all this just part of a particular – and peculiar – type of negotiating strategy / the art of the deal?

The second alternative is to treat what’s happening here as something much more fundamental: an unwinding of the old global economic order that is taking the form, at least in part, of a planned decoupling of the US and Chinese economies. Previously the economic linkages between the two – once seen as so close that it prompted the description Chimerica – served as one of the engines of the world economy. But a geopolitical realignment is now prompting a geoeconomic restructuring. If that interpretation is the correct one, then the complex process of disentangling the two economies and creating a new-look economic order still has a long way to run.

Complicating this is that the two hypotheses are hard to tell apart: a breakdown of the global order would be expected to generate high levels of uncertainty, while very high levels of uncertainty are inevitably going to be damaging to the longevity of that same order.

Either way, the profile of global economic risk is far from encouraging.

What I’ve been reading: articles and essays

RBA Governor Lowe’s remarks at the Jackson Hole gathering of central bankers. His message to the world’s central bankers was like the message he has been giving here at home: ‘that monetary policy is just one of the levers that are potentially available for managing the economy. And, arguably, given the challenges we face at the moment, it is not the best lever.’ His comments also set out the optimistic case for Australia’s economic resilience in the face of large global shifts, pointing to the combined effects of the flexible exchange rate, well-developed financial markets, the ability to issue debt in Australian dollars (or to remove exchange rate risk by using those same financial markets), a strong institutional structure, and – sometimes a source of past angst but turning out to be quite helpful in the current context – our limited integration into global manufacturing supply chains.

The full agenda and accompanying papers of the Fed’s annual Jackson Hole Symposium can be found here.

RBA Deputy Governor Guy Debelle on the significant changes in Australia’s external position. Debelle notes that Australia’s current account deficit is now the smallest it has been as a share of the economy since the 1970s while the trade surplus is about the largest it has been since the 1950s, which in turn means that Australia’s net foreign liabilities are now at their lowest as a share of GDP since the early 2000s.

CoreLogic’s Cameron Kusher reckons that the improving trend in the Australian housing market is ‘quite real’.

The Economist has a briefing on Corporate purpose, which looks at the familiar debate around the challenges of reconciling ambitious views of the capacity for business to ‘do good’ with the fundamental need to deliver reliable returns to shareholders (which, of course, can itself be seen as a social good).

Chad Brown and Douglas Irwin on Trump’s assault on the global trading system.

Robin Wigglesworth outlines fears about the ‘Japanification’ of the world economy, noting that negative yielding bonds have spread from being a largely Japanese phenomenon to account for a rising share of the global bond market.

Some high-profile names at the BlackRock Investment Institute have some suggestions on how to deal with the next downturn (pdf): in their view, better coordination between fiscal and monetary policy is what’s required.

An interesting summary of a recent ECB conference looking at the effects of digitalisation on the economy, including for labour markets, productivity, investment and inflation.

1 Note that, as flagged above, there’s a discussion of the yield curve and its efficacy as a forecasting tool in the latest of our Dismal Science podcasts, which you should be here.