Remember when trade wars were “good and easy to win”?
Oh, how we all long for a return to the halcyon days of … errr… March?
When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win. Example, when we are down $100 billion with a certain country and they get cute, don’t trade anymore-we win big. It’s easy!
— Donald J. Trump (@realDonaldTrump) March 2, 2018
I don’t know where Donald Trump got the idea that Xi Jinping is a man with whom one wants to fuck, but somewhere along the way, he (Trump) seems to have gotten the impression that he was going to be able to strong-arm the second most powerful man on the planet (the first being Putin and well, that’s another story).
What makes this so bizarre is that given Trump’s admiration for autocrats, you’d think he would have some vague conception of the extent to which “the King of China” is both a dictator and a strongman and thereby not amenable to being bullied by hapless real estate developers with delusions of grandeur. I mean, just think about what Trump has said about Kim Jong-Un lately (e.g., Kim being a “tough guy” whose people “stand at attention” when he speaks). That’s Kim Jong-Un. This is Xi-fucking-Jinping.
Whatever the case, things have gone demonstrably off the rails over the past five days when it comes to trade and Trump is starting to find out that generally speaking, there is nothing “good” about starting a fight with Xi and there is no world in which that fight is “easy to win”.
— Ivan the K™ (@IvanTheK) June 19, 2018
Chinese equities of course plunged on Tuesday as they came off the holiday to news that the Trump administration is looking for another $200 billion worth of Chinese goods to tax in an effort to “punish” Beijing for retaliating against last week’s U.S. escalation.
I mentioned this morning that China’s decision to eschew more OMO hikes last week in the wake of the hawkish Fed was probably evidence that the PBoC will end up needing to adopt a more dovish policy stance going forward in light of decelerating economic activity and rising trade tensions. I was looking through some notes and it looks like everyone generally agrees with Goldman’s take cited earlier. Here’s BNP, who expects China to take a more broad-based approach in the form of a full-on policy review:
May’s statistics show weaker growth performance and increasingly inconsistent statistics, intensifying market concerns over decelerating growth and financial stability. Economists in China are divided over the reasons behind the adverse changes and on policy perspectives. But the consensus is that growth will face more downward pressure. Our outlook on China has been more conservative than that of market consensus. The cautious forecast is now further intensified by the US-led trade war against China. Growth momentum may have weakened and financial risks increased beyond desirable levels. It is likely that an earlier Beidaihe meeting will take necessary policy actions. But instead of loosening monetary and financial regulation and policy, we expect the government to stimulate investments in tech upgrading and consumption promotion. As all new policy measures to promote domestic demands will likely take time, the policymakers should manage social expectations of lower growth rate.
SocGen’s Kit Juckes agrees. “Tariffs will deliver higher prices to the US and weaker growth to China [and] in due course we will find out how Chinese policy-makers respond,” he writes, in a note dated Tuesday, adding that while “Econ 101 suggests easier monetary policy and a weaker currency, the Chinese preference for FX stability also needs to be taken into consideration.”
Right. Because the problem with devaluing the yuan or cutting rates is that either way, you raise the odds of capital flight (devaluation leads to expectations of further currency weakness and cutting rates widens the policy divergence between the U.S. and China and potentially leads to widening rate differentials).
Meanwhile, back at Ponderosa, Trump is about to exacerbate the situation for Jerome Powell. Or at least that’s a possible side effect. Note Kit’s reference to tariffs “deliver[ing] higher prices to the US.” Analysts and economists have been warning since March that past the initial $50 billion (i.e., once you start getting into the proposed list attached to the $100 billion figure and now the $200 billion number), you inevitably end up driving up prices for U.S. consumers.
“USD 200bn of goods represents over a third of likely 2018 imports from China,” the above-mentioned Juckes writes, in the same note. “The important point to note about the escalation, which will surely result in a Chinese response, is that while the tariffs imposed may be lower on the expanded range of goods, they will include more consumer goods, and therefore have a more direct impact on US consumers apart from anyone else.”
And see therein lies the problem for Jerome Powell. Over the weekend, in a fun post complete with a signature Heisenberg bar vignette, I excerpted the latest note from Deutsche Bank’s brilliant Aleksandar Kocic who described the Phillips curve as follows:
Through the last four cycles, Phillips curve has asserted its importance in an unorthodox way and, as such, attained a special status; it inhabits a space different from other macroeconomic frameworks and metrics. In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role. It appears “indestructible”, but not in a conventional way, more like a survivor of one’s own death. Phillips curve functions like an organ without a body, an equivalent of Cheshire cat’s smile (in Alice in Wonderland) that persists alone, even when the cat’s body is no longer present. This time is no different in our view. The figure shows the Philips curve through several cycles starting in mid-1980s. Each cycle has a different color which implicitly marks their beginning and end. The first thing one observes is that this is more of a “spaghetti” then a curve. The main reason is that it captures different cycles – a testimony to its falling apart and recomposing itself after each.
What you’re looking at there are the vertical lines at the end of recoveries. As Kocic goes on to write, “in the past, this stage always exhibited a dramatic (practically straight line) rise in wages in response to infinitesimal improvements in economic activity.”
Clearly, the worry is that wage inflation abruptly accelerates and the Fed is caught flat-footed by the suddenly not flat curve. Next up: stagflation.
Well, consider that in the context of the tariffs and, more broadly, in the context of the effort to roll back globalization.
“Economic theory suggests that globalization is likely to have had a negative effect on inflation both in terms of its level as well as its volatility,” Barclays writes, in a note dated June 7. They cite four factors to support that contention, one of which is the idea that “trade can increase price and wage flexibility domestically, leading to a flattening in the Phillips curve.” Here’s some technical work:
Figure 8 shows different specifications of a reduced form Phillips curve involving domestic and foreign variables, pooled across G10 countries over two sample periods, 1985-2003 and 2004- 2016. The inflation-domestic output gap sensitivity has declined substantially, whereas the sensitivity to external prices (import prices) and the global output gap has increased, coinciding with the period of rising globalization. Figure 9 confirms that inflation has been negatively related to openness for a number of G10 and EM countries, but this sensitivity is particularly low among G10 countries (Figure 10). We find that increased openness has coincided to the decline in inflation globally, even after controlling for output gaps and central bank independence in a pooled regression.
While they do note that EM is more sensitive to these dynamics than DM, the takeaway is that, quote, “a reversal of trade integration/openness trends implies a steeper Phillips curve, increased sensitivity to domestic economic conditions, higher inflation outcomes in the long term (all else equal) and higher inflation volatility.”
So is it possible that Trump’s policies will exacerbate the late-stage Phillips curve dynamics described by Deutsche Bank’s Kocic?
It would appear so, and you can bet the Fed is cognizant of that possibility.
And there’s something so fitting about this analogy, right? After all, traders wake up everyday feeling like Alice…
Alice: But I don’t want to go among mad people.
Cat: Oh, you can’t help that. We’re all mad here.