Despite the downward pull of a prospective no-deal Brexit, the UK’s services sector defied gravity for a second successive month, with the IHS Markit/CIPS UK services purchasing managers’ index (PMI) showing a reading of 51 for May, up from 50.4 in April and ahead of analyst consensus. Admittedly, the figure comes after negative readings for the UK manufacturing and construction sectors, but it makes you wonder how the economy would be chugging along without the existing political impasse.
Certainly, there are few signs of a deflationary trap. Some commentators have drawn parallels between the UK’s economy and that of Japan’s at the turn of the millennium, with feeble real earnings growth combined with unemployment at a multi-decade low. Staffing levels did increase through May, with the latest data indicating a “modest rate” of job creation, albeit the strongest since November 2018. The Bank of England has all but exhausted its options to trigger economic growth, but with input prices on the rise due to higher transport and, critically, wage costs, there is no need for the Old Lady of Threadneedle Street to apply the defibrillator just yet.
We can safely assume that Brexit-linked uncertainties have been adequately priced into UK equities, but it’s more problematic with Donald Trump’s recent initiatives in relation to China and Mexico. It’s unsurprising that the US president has resumed hostilities with China after claims by government officials that Beijing had back-peddled on trade agreements. But the imposition of tariffs on Mexico took markets by surprise, even though there was certainly evidence the president was determined to stem the flow of illegal immigrants crossing the US southern border from Central American countries including El Salvador, Honduras and Guatemala.
The world’s two largest economies have been in an escalating conflict over trade for the past 12 months or so. But the scope of the dispute has widened, with security issues to the fore following tightened trade restrictions on Chinese telecoms giant Huawei. Hopes for an imminent trade deal were dashed last month when the Trump administration more than doubled tariffs on $200bn (£157bn) of Chinese imports and threatened additional duties. China retaliated with tariffs worth $60bn on imports from the US. The resultant numbers are significant. China's export volumes to the US fell by 9.7 per cent year on year in the first quarter due to the US tariff measures, while direct investment by Chinese companies into the US has declined by a similar margin.
The president, unconvinced by Mexico’s efforts to stem the human tide, announced a 5 per cent tariff on all imports, with the option of increasing the rate if government officials prove recalcitrant. Mexico relies heavily on cross-border trade, so the peso duly tumbled, along with US stock index futures, while Asian stock markets also pulled back, including the shares of Japanese carmakers that export from Mexico into the US.
There can be no doubt that the escalating trade war represents a drag on the global economy, but it’s transparently a more severe issue for emerging market (EM) economies. EM stock markets and US dollar-denominated EM sovereign bonds started 2019 on a tear, but increased trade friction – and the fear of a prolonged tariff regime – could conceivably trigger an EM downturn.
EM outperformance in the early part of the year has been linked with a loosening of monetary policy by the US Federal Reserve, somewhat ironic given that it was probably on the top of Donald Trump’s Christmas wish list. A less hawkish stance generally lowers the cost of financing due to the greenback’s status as the global reserve currency (higher interest rates can make it more expensive for overseas borrowers to service their dollar-denominated debt commitments). It’s not solely about negative implications for the Chinese economy, another danger to EM economies stems from the fact that even if the Fed leaves interest rates where they are, the dollar could still conceivably appreciate against EM currencies if the US economy outperforms relative to EM counterparts.
Recent analysis from MSCI assessed the vulnerability of EM equities (excluding China) through their sensitivity to the US dollar, against a trade-weighted basket of non-US currencies. MSCI notes that “the relationship was consistently negative” over the past decade, meaning that EM debt and equity “generally took a hit when the US dollar strengthened”.
A strengthening dollar would draw in further capital to the US, reversing the prevailing capital flows. This is important because several EM economies, including Brazil and Turkey, are reliant on foreign inflows to fund fiscal or current account deficits.
Trade tensions have reignited just as China’s economic growth rate, which has been in secular decline, started to stabilise on the back of government initiatives to reduce value-added tax for the manufacturing, transportation and construction sectors. Aside from the US/China/Mexico spat, EM economies have had to deal with specific issues. In South Africa, for example, markets went into reverse after the government was forced to bail out Eskom, the state-run power company. And the Russian economy is still operating under a sanctions regime, although rising energy prices have provided a modicum of relief.
