The US-China conflict challenges the world

Smaller countries should band together to sustain multilateral free trade

Martin Wolf

Where does deepening economic conflict between the US and China leave the rest of the world, especially historic allies of the US? In normal circumstances, the latter would stand beside it. The EU, after all, shares many of its concerns about Chinese behaviour. Yet these are not normal circumstances. Under Donald Trump, the US has become a rogue superpower, hostile, among many other things, to the fundamental norms of a trading system based on multilateral agreement and binding rules. Indeed, US allies, too, are a target of the wave of bilateral bullying.

So what are American allies to do as the US and China battle? This is not just about Mr Trump. His focus on bilateral trade balances may even be relatively manageable. Worse, a large proportion of Americans shares a deepening hostility not just to China’s behaviour, but to the fact of a rising China.

We are also seeing a big shift in conservative thinking. In 2005, Robert Zoellick, deputy secretary of state, argued that China should “become a responsible stakeholder” in the international system. Recently, Mike Pompeo, secretary of state, has indicated a different perspective. Foreign affairs specialist Walter Russell Mead describes Mr Pompeo’s animating idea as follows: “Where liberal internationalists believe the goal of American global engagement should be to promote the emergence of a world order in which international institutions increasingly supplant nation-states as the chief actors in global politics, conservative internationalists believe American engagement should be guided by a narrower focus on specific US interests.” In brief, the US no longer sees why it should be a “responsible stakeholder” in the international system. Its concept is, instead, that of 19th century power politics, in which the strong dictate to the weak.

This is relevant to trade, too. It is a canard that the trading system was based on the notion that international institutions should supplant nation states. The system was built on the twin ideas that states should make multilateral agreements with one another and that confidence in such agreements should be reinforced by a binding dispute settlement system. This would bring stability to the conditions of trade, on which international businesses rely.

All this is now at risk. The spread of the tariff war and the decision to limit the access to US technology of Huawei, China’s only world-leading advanced technology manufacturer, seem aimed at keeping China in permanent inferiority. That is certainly how the Chinese view it.

The trade war is also turning the US into a significantly protectionist country, with weighted-average tariffs possibly soon higher than India’s. A paper from the Peterson Institute for International Economics states, that “Trump is . . . threatening tariffs on China that are not far from the average level of duties the United States imposed with the Smoot-Hawley Tariff Act of 1930.” Tariffs may even stay this high, because the US’s negotiating demands are too humiliating for China to accept. These levies will also lead to diversion to other suppliers. Tariffs may then spread to the latter, too: bilateralism is often a contagious disease. Contrary to Mr Trump’s protestations, the costs are also being borne by Americans, especially consumers and farm exporters. Ironically, many of the worst hit counties are in Republican control. (See charts.)

Some might conclude that the high costs mean that the conflict cannot be sustained, particularly if stock markets are disrupted. An alternative and more plausible outcome is that Mr Trump and China’s Xi Jinping are “strongmen” leaders who cannot be seen to yield. The conflict will then either remain frozen or, more likely, worsen as relations between the two superpowers become increasingly poisoned.

Where does this leave US allies? They should not support American attempts to thwart China’s rise: that would be unconscionable. They should indicate where they agree with US objectives on trade and technology and, if possible, sustain a common position on these issues, notably between the EU and Japan. They should uphold the principles of a multilateral trading system, under the auspices of the World Trade Organization. If the US succeeds in rendering the dispute system inquorate, the other members could agree to abide by an informal mechanism instead.

Most significantly, it should be possible to sustain liberal trade, at the expense of the US and China. Anne Krueger, former first deputy managing director of the IMF, notes in a column that, by its own foolish decision to reject the Trans-Pacific Partnership, the US suffers from WTO legal discrimination against its exports to members of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, which replaced TPP. The EU also has free trade agreements with Canada and Japan.

This is good. But they can go further. Countries that see the benefits of a strong trading order should turn such FTAs into a “global FTA of the willing”, in which any country willing to accept the commitments could participate. One might even envisage a future in which participants in such a global FTA would defend its members against illegal trade assaults from non-members, via co-ordinated retaliation.

Hostility between the US and China is a threat to global peace and prosperity. Outsiders cannot halt this conflict. But they are not helpless. If the big powers stand outside the multilateral trading system, others can step in. They are, in aggregate, huge players. They should dare to act as such.

China battles the US in the artificial intelligence arms race

What counts is implementation not innovation, and here the Chinese have big advantages

Martin Wolf

In late March I attended the China Development Forum for the ninth time. The visit stimulated my recent observations on China’s economy and politics. But what makes the CDF most valuable is serendipity. This time that came in the shape of a meeting with Kai-Fu Lee, former president of Google China and now a leading venture capitalist in Chinese technology.

Mr Lee gave me a copy of his new book, AI Superpowers: China, Silicon Valley and the New World Order. This has a startling story to tell: for the first time since the industrial revolution, he argues, China will be at the forefront of a huge economic transformation — the revolution in artificial intelligence.

He starts his book by talking about China’s “Sputnik moment”, when Google DeepMind’s AlphaGo defeated Ke Jie, the world’s leading player of the ancient Chinese game of Go. This demonstrated the capacity of modern AI. But, by implication, Mr Lee’s book foresees another such moment, when the US realises it is no longer leader in the global application of AI. The original Sputnik moment occurred when the Soviet Union put the first satellite in orbit in 1957. This led to the space race of the 1960s, which the US duly won. What will the present “race” lead to?

Mr Lee does not claim that China will lead in fundamental innovation in this area. But that may not matter, since the big intellectual breakthroughs have already occurred. What matters most is implementation, not innovation. Here China has, he writes, many advantages.

First, the work of leading AI researchers is readily available online. The internet is, after all, a superlative engine for spreading intellectual breakthroughs, not least including those in AI.

Second, China’s hypercompetitive and entrepreneurial economy lives by Facebook founder Mark Zuckerberg’s notorious motto: “move fast and break things”. Mr Lee describes a world of cut-throat business activity and remorseless imitation, which has already allowed Chinese businesses to defeat leading western rivals in their home market. The ceaseless “trial and error” of the Chinese business model is, he argues, well suited to rolling out the fruits of AI across the economy. It could, for example, work far better in introducing autonomous vehicles than the west’s safety-conscious approach. China’s swarms may be inefficient, but they are effective. That is what matters.

Third, China’s dense urban settlements have created a huge demand for delivery and other services. “American start-ups like to stick to what they know: building clean digital platforms that facilitate information exchanges,” Mr Lee argues. But Chinese firms get their hands dirty in the real world. They integrate the online and offline worlds.

Fourth, China’s backwardness allowed businesses to leapfrog existing services. So China has been able to jump to universal digital payment systems, while western businesses still use outdated technology.

Fifth, China has scale. It has more internet users than the US and Europe combined. If data is indeed the fuel of the AI revolution, China simply has more of it than anybody else.Sixth, China has a supportive government. Mr Lee cites a speech by premier Li Keqiang in 2014 at the World Economic Forum’s “summer Davos”, calling for “mass entrepreneurship and mass innovation”. In his report “Deciphering China’s AI Dream”, Oxford university’s Jeffrey Ding points to the State Council’s national strategy for AI development. China’s government has ambitious goals and is willing to take risks to achieve them. One of the things China can do more easily than anywhere else is build complementary infrastructure.

Finally, writes Mr Lee, the Chinese public is far more relaxed about privacy than westerners.

Chinese leaders, it may be argued, see no justification for individual privacy at all (except for their own).
 So where is this supposed “race” between the US and China today? Mr Lee distinguishes four aspects of AI: “internet AI” — the AI that tracks what you do on the internet; “business AI” — the AI that allows businesses to exploit their data better; “perception AI” — the AI that sees the world around it; and “autonomous AI” — the AI that interacts with us in the real world. At present, he thinks China is equal to the US in the first, vastly behind in the second, a little ahead in the third, and, again, far behind in the fourth. But five years from now, he thinks, China might be a little ahead in the first, less far behind in the second, well ahead in the third and equal in the last. There are, to his mind, no other competitors.

Mr Ding analyses the drivers differently. He distinguishes hardware, data, research and the commercial ecosystem. China is far behind the US in production of semiconductors, ahead in the number of potential users and has about half the number of AI experts and roughly half the number of AI companies. All told, China’s potential is about half that of the US. Yet Mr Ding is looking at AI overall, while Mr Lee focuses on commercial applications.

Historical experience suggests that the rents created by a lead in an important technology are valuable, though often impermanent. So, which country will be ahead in the application of AI is indeed important. But the economic and social impact of AI is a bigger issue and one that is relevant to every country.

As Mr Lee stresses, advances in AI offer gains. This is not just in personal convenience, but in improving medical diagnostics, tailoring education to individual students, managing energy and transport systems, making courts fairer, and so on and so forth.

Yet AI also threatens huge upheavals, notably in labour markets. Many of the jobs (or tasks) that AI might do are today done by relatively educated people. It seems reasonable to fear that AI will accelerate the hollowing out of the middle of the earnings distribution, possibly even the upper middle, while increasing concentrations of private wealth and power at the top.

Yet perhaps the most important consequence will be in the intensity of influence and surveillance made possible by AI-monitored mobile devices and sensors. George Orwell’s Big Brother (or many big commercial brothers) might watch us all the time. Such perfect monitoring might be attractive to China’s state. It is horrible to me and, I hope, billions of others.

AI, Mr Lee insists, is not the same as artificial general intelligence: the true super brain is far away. Even so, the challenges this AI creates are huge. We will not stop it. But we may in the end conclude we have birthed a monster.

The Terrifying Truth About Negative Interest Rates

Pushing interest rates below zero is both an act of desperation and something that in theory should have a huge, immediate impact of the behavior of borrowers and savers. The fact that negative rates have become the new normal in big parts of the world but haven’t caused the expected behavior change should scare the hell out of everyone.

To understand why this is so, think of the rate of interest as the price of money. It’s what an individual or business has to pay to get credit with which to buy and invest. As with anything else, when the price of money is high, we tend to acquire less of it and when the price is low we acquire more. So making money not just cheap, not just free, but actually profitable to borrow, while making savings unprofitable to hold should, according to conventional Keynesian economics, create a scene in the credit markets reminiscent of those Black Friday Wal-Mart videos where fistfights break out over the last remaining Barbie Doll. Businesses in particular should be borrowing and investing like crazy, igniting an epic capital spending boom.

But that hasn’t happened. In Europe, for instance, negative rates have been in place for five years …

negative interest rates Europe

… and instead of a rip-roaring post-Great Recession recovery, the result has been the kind of anemic growth that conventional economics would predict for a tight-money environment.

Business capital spending, the engine that in theory should be propelling Europe’s economy, looks like the opposite of a boom.

Europe capital spending negative interest rates

This translates into seriously boring GDP growth:

Europe negative interest rates Europe

Why call such an uneventful situation terrifying? Because of what comes next.

Europe’s current sub-2% average growth rate is too slow to stop debt-to-GDP from rising. In other words, even with negative interest rates the Continent continues to dig itself ever-deeper into a financial hole. The same death spiral dynamic is in place in US, Japan and China.

To put the problem in more familiar terms, the world’s central banks have launched their version of tactical nukes at the problem of slow growth and soaring debt, and the dust has cleared to reveal the enemy unscathed and coming back for another go.

The next recession will begin with interest rates already at emergency levels, leaving central banks with no choice but to launch even bigger nukes. If interest rates are currently at -0.5%, then push them down to -5%. If buying up every investment-grade bond didn’t work last time around, then buy up junk bonds and equities, and maybe pay off everyone’s mortgage and student loans.

This will also fail, for reasons best explained by the unfortunately non-mainstream Austrian School of economics. The Austrians focus on a society’s balance sheet and observe that when low-quality (that is, speculative) debt exceeds certain levels, there’s nothing to be gained by encouraging more borrowing. So go ahead and cut interest rates to any crazy level you want.

The inevitable, necessary result of too much bad debt is a crash that wipes that debt out. Or a hyperinflation that destroys the currency with which desperate governments flood the market in an attempt to stave off the debt implosion.

This explains why today’s negative interest rates haven’t ignited a boom (there’s already too much bad paper circulating), and also why the next round of monetary experiments will fail even more spectacularly.

The US is seeking to constrain China’s rise

Ban on companies supplying Huawei is damaging and ill-conceived

The editorial board

However great the vulnerabilities in Huawei and the broader Chinese tech sector that they have revealed, the US steps may also ultimately fail © Reuters

Huawei is under siege. Google is restricting parts of its Android operating system to the Chinese telecoms tech giant. US chipmakers are poised to suspend supplies too. The US move to put the Chinese telecoms flagship on its so-called Entity List — requiring American companies to obtain a government licence to sell to it — is a pivotal moment for the global technology industry. It represents an opening salvo in an emerging new US-China cold war. It is also a serious miscalculation.

All countries have a right to protect national security interests — nowhere more than in 5G telecoms, nervous system of the future digital economy and the “internet of things”. The Trump administration’s moves last week, however, go far beyond what is needed to address security concerns. They also seem far more than an attempt to pressure Beijing into reaching a trade deal.

They amount to an effort to decouple the US and Chinese tech sectors, leading to a bifurcation of the global industry. This reflects a view reaching beyond the Trump White House and deep into the US security establishment that President Xi Jinping’s China is a malign actor, and that its technology is on course to outstrip America’s. Indeed, the US steps appear part of an attempt to constrain China’s rise.

Echoes of the Soviet era abound, but Soviet industry was never entwined with America’s in the way China’s is. The latest US moves seem designed to cripple or crush one of the first Chinese tech companies to become globally competitive — and one that relies on American suppliers in both mobile phones and network equipment.

Assuming the US administration sticks to its measures, despite heavy lobbying by US businesses, they will damage American and other western corporate interests. Allied capitals will resent the White House’s efforts to impose its writ.

However great the vulnerabilities in Huawei and the broader Chinese tech sector that they have revealed, the US steps may also ultimately fail. They are likely to spur a Beijing-led effort to address China’s weaknesses and develop a fully independent supply chain. A historical analogy might be China’s nuclear weapons programme: the departure of Soviet advisers in the late 1950s forced it to build its own A-bomb. The result could hasten a splintering of the internet and associated technologies to which China and Russia, which recently passed a law ensuring it can cut itself off the world wide web, have already contributed.

Indeed, while China is complaining bitterly about the US moves, Beijing must take a good share of the blame for the situation it is now in. China has blocked multiple foreign companies and websites, including Twitter, Facebook, and Google services including Gmail and YouTube. The number of European companies compelled to hand over technologies in exchange for market access in China has doubled in two years, a report showed on Monday. While western intelligence agencies disagree on the size of the security threat Huawei represents, all point to China as the biggest source of cyber attacks on security and industrial assets.

If China wishes to change its image as a malign force, it must rein in such attacks. Yet Washington’s coercive steps are misguided. The US and the west should not seek to block China’s rise but encourage it to co-operate in a rules-based system, by setting good examples themselves. Washington’s allies should be free to determine what steps they judge necessary to combat security threats from Huawei or others. The US has the right to take security steps too — but not to allow these to slide into destabilising protectionism.

Suddenly, There's Not A Lot To Like

by: The Heisenberg
- Over the past three weeks, the macro narrative has taken a decisive turn for the worst.

- The Huawei bombshell looks to have made negotiations between the US and China all but impossible in the near term and Beijing is circling the wagons.
- It wasn't clear that China's economy was out of the woods and the renewed trade tensions muddy the waters considerably.
- Meanwhile, things are going off the rails in Italy again ahead of the EU elections.
It took three business days from time the US effectively blacklisted Huawei for the Trump administration to offer a concession in the form of a temporary general license that permits some transactions with the company and its dozens of non-US affiliates.
Until August 19, Huawei is permitted to buy American goods necessary to ensure existing networks remain operational and to update software on existing Huawei devices.
The decision came on Monday evening, following what I described over on my site as a "mini-panic" across the global technology supply chain. Last week, in a post for this platform, I suggested the Huawei gamble was something of a "crossing the Rubicon" moment for markets. In that post, I flagged the SOX (SOXX), which, through Friday, was headed for its second-worst month since May of 2012. By the closing bell on Monday, semi stocks were on track for their worst month since the crisis.
You didn't have to be any kind of seer to know that some manner of intervention from the US Commerce Department was in the cards. Monday wasn't an especially bad day for global equities on the whole, but the rout in semis was disconcerting for what it telegraphed about how the market was interpreting the Huawei decision. Literally minutes before the temporary general license announcement was posted to Commerce's website, I said the following in a short little post called "When The Chips Are Down":
Presumably, the Commerce Department will be forced to adopt some kind of middle ground that ameliorates market concerns and helps cushion the blow. Otherwise, this is going to quickly erode confidence. Given that the weakness in the chip space is indicative of an actual, real-world bid to dismantle the global technology supply chain, it’s difficult to imagine how this doesn’t spill over and prompt an across-the-board rout at some point in the very near future unless the Trump administration comes forward with something definitive regarding how they plan to mitigate the fallout from last week’s decision.
If you looked out across the headlines on Tuesday evening, most financial media outlets attributed Wall Street's good day to the temporary, partial reprieve granted to Huawei. The SOX rallied more than 2% and the SPDR S&P Semiconductor ETF (XSD) bested the S&P ETF (SPY) after three consecutive days of grievous underperformance. The yellow, dashed lines in the following visual mark the day the Huawei ban was announced.
To be clear, a 90-day partial reprieve from Wilbur Ross isn't going to cut it when it comes to restoring confidence and convincing market participants that the US fully appreciates the gravity of this situation. You might think the rout in the chip space is over done, but the reality is that nobody knows where this is headed. "We would expect that many, if not most, semiconductor companies will need to lower estimates," Raymond James wrote Tuesday, in a note cited by Bloomberg for a piece aptly entitled "US Chipmakers Preparing for China Trade Fight Fear That All Will ‘Suffer’".
Beyond the ramifications for semis, investors should step back and try to appreciate the big picture. I've attempted to communicate why the Huawei story is so momentous in at least a half-dozen posts over the past four days in addition to the two linked above. This is China's crown jewel on the line. Huawei is Beijing's national champion. Although the rhetoric from Chinese state media was already pretty shrill following the Trump administration's move to more than double the tariff rate on $200 billion in Chinese goods, the tone became overtly hostile following the Huawei decision. In remarks cited by a widely-read piece in the South China Morning Post, Xi on Tuesday appeared to suggest that China is preparing for an indefinite war of attrition.
Also on Tuesday, Bloomberg said the Trump administration has "for months" held off on punishing Huawei for fear of undermining the trade talks. That might sound like an innocuous headline, but it's not. Since the arrest of Meng Wanzhou in December, US negotiators have been at pains to insist that trade talks are separate from national security concerns. Implicit in that insistence was a promise that Huawei and Meng wouldn't be used as leverage. The Bloomberg story (which cited unnamed sources) suggests the US always intended to play the Huawei ace in the event the terms of a prospective trade deal weren't deemed favorable enough for Washington.
Importantly, some of China's recent stimulus efforts have been inward-looking, seemingly designed to bolster domestic demand rather than rescue the global cycle. That could be due to worries that the monetary policy transmission channel is clogged by lackluster demand for credit, or it could just be that Beijing is taking a "China first" approach this time around when it comes to stimulus. Whatever it's attributable to, it's reasonable to assume that in an all-out trade war scenario, that tendency to focus inward will be redoubled. Consider this from Barclays:
China’s stimulus has failed to boost exports from trading partners like Korea and Taiwan implying that China’s stimulus is domestically oriented and that the improvement in fixed asset investment is driven by real estate/ infrastructure at the expense of manufacturing, thereby increasing the efficacy of the policy measures domestically and limiting the amount of pass-through of this stimulus to the rest of the world. We therefore see risks of a prolonged and soggier soft patch in the global economic recovery compared to 2016. 
When you throw in the fact that April activity and credit growth data missed estimates, you're left with somewhat vexing concerns about the outlook in an environment where the US is turning the screws as tight as they'll go.
With that in mind, remember that for the better part of a decade, China has been the engine of global growth and credit creation. That's a point that's been emphasized and reemphasized by analysts since 2015, when the yuan devaluation rattled markets and China concerns were top of mind.
"Following the Global Financial Crisis, Washington had too many problems to focus on China, plus the Chinese were the driving force behind global GDP and debt creation after 2008 in a world hungry for growth," Bank of America writes, in a note dated Monday, adding that "the European sovereign debt crises of 2011 and 2012 made Chinese economic activity an even more important pillar of the world economy."
The recovery from the crisis has been tepid, and although 2017 was characterized by synchronous global growth, "gangbusters" isn't a term you'll hear anyone use to describe the pace of economic expansion in developed economies. There will probably never be an "ideal" time to confront Beijing on trade, and it's true that fiscal stimulus in the US has given the Trump administration a growth cushion (so to speak) when it comes to pushing the envelope, but there is a certain sense in which undercutting China's economy amounts to cutting one's nose of to spite the face.
At the same time, the renewal of trade concerns is weighing heavily on emerging market equities which have now erased most of their gains for the year. Notably, recent underperformance has pushed the ratio of the iShares MSCI Emerging Markets ETF (EEM) to the S&P ETF below 2018's nadir (top pane).
Meanwhile, things are going off the rails in Italy again - perhaps you've heard. Matteo Salvini has ratcheted up his signature budget bombast ahead of the EU elections and there's rampant speculation he may attempt to capitalize on League's popularity by forcing a government shakeup.
The bickering between League and Five Star is becoming wholly untenable and it's doubtful that Salvini wants to wait too long to make a move lest the Italian economy should decelerate anew and/or Italian assets succumb to another bout of turmoil on par with what we saw last May. Amid the tension, Italian stocks are on track for their first losing month of the year (bottom pane in the visual above).
Here's a bit of color from Goldman that gives you some perspective on Italy in the context of the recent risk-off mood (this is from a note out Tuesday):
In order to assess how the deteriorating macro picture has influenced performance, we benchmarked cross-asset performance to the recent changes of our first three GS risk appetite indicator factors: global growth, monetary policy and the dollar. We found that cross-asset performances since beginning of month have been in line with their implied return, except the Banks sector which has underperformed materially. 
Note that the FTSE MIB (i.e., Italian stocks on the whole) have actually performed inline with their implied beta, which means that things could get a lot worse for Italian equities in the event decent earnings are no longer sufficient to offset concerns about the banking sector, where exposure to the sovereign is actually running near historical highs.
To be clear, monetary policymakers are on high alert and will do what they can. The RBA minutes and a speech from Philip Lowe on Tuesday telegraphed a rate cut and the market still expects Fed easing. Meaningful ECB and BoJ normalization is out of the question for the foreseeable future.
Whether central bank accommodation will be enough this time around is debatable.
In case it didn't come through in all of the above, my current view is that there's not a lot to like about the setup right now.
Take that for what it's worth.


A Tale of Two Yield Curves

By Daniel Kruger, bond market reporter

Investors and Federal Reserve officials watch the gaps between shorter- and longer-term interest rates to gauge the health of the U.S. economy. Right now, the two groups are seeing different things.

That’s because they use different measures. Fed economists tend to study the difference between the yield on the three-month Treasury bill and the yield on the benchmark 10-year Treasury note. The three-month yield this year has periodically exceeded the 10-year yield, a phenomenon known as an inverted yield curve that has preceded every recession since 1975.

Many investors, however, prefer to watch the gap between the yields on 10- and two-year notes, saying moves in two-year debt can reflect expectations for Fed policy over a longer period than just the next meeting or two. And the two-year yield has held below that of its longer-term counterpart.

The benchmark 10-year Treasury yield settled Monday at 2.416%. That was 0.193 percentage point higher than the two-year yield and 0.034 percentage point higher than the rate on three-month government bills. The three-month yield most recently exceeded the 10-year yield on May 15.

One reason for the difference: the yields on two-year Treasurys reflect growing odds that the Fed will lower interest rates during the life of the debt, some analysts said. Investors aren’t betting that’s likely within the next three months, which is why three-month yields are about a quarter of a percentage point higher.

The risks facing the economy make Treasury debt maturing in two- to five-years attractive, pulling yields lower than those on shorter-term bonds, some investors said. While few forecast an imminent recession, trade tensions have spurred fears about the prospects for growth and a potential erosion of inflationary pressures that could lead to rate cuts.

The economy grew at an annualized 3.2% in the first three months of 2019 while the jobless rate fell to an almost-50-year low of 3.6% in April. Yet three measures of inflation data for April fell short of economists' expectations, reinforcing the Fed’s recent concerns about softening price pressures.

“It’s difficult to argue that the economy is weakening,” said Donald Ellenberger, head of multisector strategies at Federated Investors. At the same time, “the Fed is desperately trying to push inflation up,” he said.

A Tail Risk The Fed Can't Solve

by: The Heisenberg
- The latest edition of one bank's closely-watched fund manager survey shows a wholly unsurprising top tail risk.

- Although the pros are worried about the right thing, and have apparently taken out portfolio hedges, the level of concern seems inadequate.

- That goes double when you consider there's no credible monetary policy response to a worsening of trade tensions.

In the latest edition of Bank of America's closely-watched Global Fund Manager survey, the number one tail risk is "trade war".
"That's no surprise given the survey was taken May 3rd-9th, but trade war concerns are well below levels seen last summer," the bank's Michael Hartnett wrote this week.
Here's the visual which illustrates Hartnett's point:
When you consider that "China slowdown" worries are in part a manifestation of the trade war, it's fair to say that global fund managers have identified the trade conflict as the top tail risk for 14 of the last 15 surveys. The latest edition tallies results from a total of 250 respondents, who together manage nearly $700 billion in AUM.
Hartnett's point about conviction in what the top tail risk is not being as high as it was last summer might seem trivial, but it's not. Note that last August, some two thirds of respondents identified "trade war" as the biggest tail risk. That figure was just 37% in May.
Since August, there have multiple escalations between the US and China, including, of course, the Trump administration's recent decision to more than double the tariff rate on $200 billion in Chinese goods, China's subsequent threat of retaliation, the specter of tariffs on all Chinese exports to the US and, on Wednesday, the de facto banning of Huawei.
To be fair, the survey period noted above doesn't capture the Huawei news and it also misses another week of losses for the yuan, but the point is, the relative sanguinity (versus last summer) looks misplaced to me.
On Friday, I spent some time writing a lengthy post for this platform outlining why some believe the Huawei news might have been the straw that broke the camel's back for the trade talks. Not everyone agrees with that assessment. The US election in 2020 raises the stakes for the Trump administration and one might well argue that the US president wouldn't risk the talks with China collapsing (or an all-out trade war) for fear of economic blowback and what a falling stock market would mean for his reelection bid. That said, I continue to believe the calculus is more complex than that.
In any event, respondents to BofA's survey believe the vaunted "Fed put" (in this case, the level at which the Fed would actually cut rates, although it's not necessary to conceive of the Fed put as manifesting itself in overt easing) is struck some ~22% below the highs.
Fed put
That's probably too extreme. That assumes the Fed put wasn't re-struck higher following the December lows (i.e., that it still corresponds to an SPX beta of roughly 10 to the short rate). I doubt that's the case. That is, the Fed put isn't 20% out of the money. "Between June and December of 2018, the S&P followed a beta = 23 trajectory," Deutsche Bank wrote in a Friday note, adding that "when the market tested the Fed's resolve and sold off almost all the way to the [previous] put strike... a subsequent dovish Fed response [led to] a recovery of stocks all the way back to current levels." Assuming the beta = 23 trajectory, the Fed put is likely around S&P 2600.
The problem with even talking about the Fed put right now is that the central bank would arguably be wading into dangerous waters by cutting rates in response to trade-related market frictions. It's true that past a certain point, stock price declines serve to tighten financial conditions, and widening credit spreads exacerbate the situation, ostensibly calling for a monetary policy response. Right now, though, Fed cuts in the context of an escalating trade war could well encourage further escalations, as competitive easing emboldens politicians on both sides of the dispute to push the envelope knowing they have monetary policy cover. Those additional escalations could eventually snowball until tit-for-tat protectionism manifests itself in rising consumer prices and lower growth. At that juncture, monetary policy is constrained on the easing side by higher inflation and on the tightening side by slowing economic activity.
Meanwhile, the credibility of a central bank which participates in a trade war will have been damaged.
There's more on the Fed put and the quandary described above here, but suffice to say there aren't many good options when it comes to a monetary policy response should trade frictions get worse.
Therefore, the better outcome would be for stock price declines to be seen by politicians as the market sending a message about the extent to which protectionism is injurious to businesses and a potential headwind to growth and economic prosperity. If that message is accepted, tensions will ease and the odds of a trade truce increase, obviating the need for the Fed to respond at all.
It's important to remember that up until the latest escalation (i.e., the doubling of the tariff rate on the $200 billion in Chinese goods that were originally taxed at 10% from September 24), the trade war hasn't really had much bite (so to speak) in terms of a quantifiable, direct economic impact. As Credit Suisse wrote last month, the "fear" of trade tensions was actually more impactful than any mechanical effect.
But that will change if the entirety of Chinese exports to the US are hit with levies and if, after a delay, the Trump administration moves forward with auto tariffs. How many commentators were sure last summer that this would all die down in relatively short order? Quite a few, if not the majority.
Well, it hasn't died down. Both the value of proposed tariffs and the value of implemented levies keeps ratcheting higher.
Value of tariffs (Goldman)
Remember, roughly 30% of S&P 500 COGS are imported. Given that and given the impossibility of overhauling globalized supply chains overnight, it is a mathematical certainty that if these tariff escalations keep coming, profits will be lower, prices will be higher, or some combination of both.
The only way that doesn't play out is if you assume a wholly unrealistic combination of higher domestic revenues (which implicitly counts on the current expansion continuing) and efficient supplier substitution. That best-case scenario which avoids margin compression and price hikes is, to my mind anyway, far-fetched in the extreme.
Meanwhile, the impact of further escalations will ricochet across the globe in classic fashion.
Here's BNP, from a note out Friday:
In the medium term, higher tariffs imply reduced competition, lower productivity and inefficient distribution of resources – i.e., a negative supply shock. In the short term, recent developments’ key impact is likely to come from a reduction in global trade and persistent uncertainty, deterring investment, encouraging precautionary savings and possibly affecting the markets through higher risk premia.
Again, this will become unavoidable at some point, and as detailed above, there won't be a Fed response that doesn't come with considerable risk.
Coming full circle to the BofA fund manager survey, consider one final excerpt that drives all of this home rather poignantly:
34% of FMS investors say they have taken out protection against a sharp fall in equity markets over the next three months, the highest level ever on an absolute and net basis (net -21% say they have taken out protection).
At least folks are well-protected.

Japan’s Banks Are About to Get Even Feebler

However the Bank of Japan responds, lenders will be hit by Prime Minister Shinzo Abe’s proposed tax increase

By Mike Bird

Prime Minister Shinzo Abe’s election in 2012 ushered in more expansionist economic policy. Photo: kazuhiro nogi/Agence France-Presse/Getty Images

Japan’s banks are the weak link in its economic framework. Prime Minister Shinzo Abe’s insistence on following through with a tax increase could make them weaker still.

On Thursday, credit-ratings company Moody’s downgraded its outlook for Japanese banks from stable to negative. The Bank of Japan ,which is holding its benchmark interest rate in narrowly negative territory, was the main cause of the downgrade.

Japanese interest rates are low because economic growth is relatively weak. That is a problem that the 2-percentage-point sales-tax increase scheduled for October will only exacerbate.

Low interest rates have driven down loan spreads in Japan, squeezing banks’ income from lending. Interest rates on new loans issued by regional banks are now well below the level the sector requires to break even, according to Shannon McConaghy, a portfolio manager at hedge fund Horseman Capital who has shorted Japan’s regional banks.

Japan’s central bankers are in a bind. Last time the government increased the sales tax, in 2014, it dinged the country’s promising economic recovery. The BOJ responded by further expanding its ambitious bond-buying program. But low interest rates make that response far less likely this time. Masayoshi Amamiya, an influential functionary who became deputy governor of the central bank early this year, has been a particularly vocal source of concerns about bank profitability.

Whatever the BOJ does, Japanese banks will take a hit. Without its intervention, the economy will likely slow as a result of the sales-tax increase. Regional banks, whose bread and butter is corporate and household loans, are particularly exposed. Japan has already suffered from spillovers from a slowing Chinese economy.

The weak position of regional banks isn’t a new theme for stock investors. Since the election of Mr. Abe at the end of 2012 ushered in more expansionist economic policy, Japanese stocks as a whole have risen by around 50%. Japan’s regional banks are down 10% over the same period.

If the government goes ahead with its tax increase, however, the sector’s problems will only get worse—and there is nothing the BOJ can do about it.

Is the World Economy Headed for a Fall?

Wharton’s Joao Gomes and Ashoka Mody from Princeton discuss the IMF’s lowered global growth forecast for 2019.

The International Monetary Fund (IMF) has once again cut its global growth forecast for 2019.

In its new semi-annual World Economic Report, the organization now projects a 3.3% growth rate, down from the 3.5% it predicted in January, 3.7% in October and 4% a year ago. Key reasons for the downward revisions: the U.S.-China trade war and the potential for a disorderly Brexit.

Added to those concerns is a general tightening of monetary policy globally, particularly the spate of interest rate increases in the U.S. IMF chief economist Gita Gopinath wrote that with 70% of the global economy seeing a slowdown in growth, it is “a delicate moment right now.”

What might strike some as the relatively small size of the recent decreases in the IMF’s forecast belies the large impact such cuts in growth can bring on the ground to people and businesses, particularly in countries already struggling that could easily be tipped into a recession. At the same time, it’s worth noting that each of the IMF concerns has been partly ameliorated more recently. The immediate Brexit risk has been pushed back by a deadline extension to October, the outlook for the U.S.-China trade war – at this moment at least — looks more sanguine, and the Fed has clearly become more dovish, making further rate increases this year unlikely and raising the possibility of a rate cut.

Plenty of concerns about the world economy nevertheless remain. “A recent collapse in global trade is the worst since the financial crisis and as steep as during the recession of the early 2000s,” notes this report from The Telegraph. Citing figures from the CPB Netherlands Bureau for Economic Policy Analysis, the report pointed out that global trade has fallen “1.8% in the three months to January compared to the preceding three months.” The article added, however, that markets seemed to be recovering in early 2019, thanks to reports that the U.S. and China appear closer to a trade accord.

Long-term Concerns

Meanwhile, there are many reasons for concern over the longer-term prospects for global growth, and even the newly revised IMF forecast is too optimistic, said Ashoka Mody, former deputy director of the IMF’s research and European departments, and Joao Gomes, a Wharton finance professor. In the short term, both expect slower growth than the IMF projects, though neither sees a U.S. recession as likely up until 2020 at least. But they noted that beyond the immediate trouble that lower global economic growth would bring is a more pervasive, long-term drift towards slower growth driven by mega trends such as China’s reaching economic maturity — and settling into a much slower growth rate — and aging populations in many of the world’s richest economies, especially China and Europe. The two experts made their comments on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

According to Mody, who is a visiting professor of international economic policy at Princeton University, “The world has been on a secular declining growth rate path. That matters because there have been brief periods when we lift off from that downward trend, and those brief periods are essentially driven by China.” The overarching problem now, however, is that China itself is trending towards slower growth. “Rich countries do not grow perpetually at 7% to 8%. Therefore, the Chinese growth rate has to come down.”

For Mody, the question is not whether China’s economic growth will slow, but how fast it will happen and “whether it can manage that without a crisis.” China occasionally pumps up its economy, but the resources to do so are thinning out. “I expect that in the second half of 2019, and certainly the early part of 2020, the Chinese economy will continue to slow. World trade will continue to slow,” he said.
Gomes agreed that China is an economic fulcrum for much of the world, along with the U.S. When China’s economy slows, it’s “a real problem for virtually most of Latin America” and Africa, mostly because of lower commodity exports and investments. The strong downward effects on many countries, such as Australia, have long been noted. “And then there’s the auto manufacturers in Europe that really depend on China and China’s market…. A lot of the slowdown in Europe has been tied to the trade wars and the prospects of the slowdown in China, and what exactly the Chinese consumers have access to now,” Gomes said.

Added to the risks in Europe are the new threats by the Trump administration to slap $11 billion in tariffs on various EU imports because of what it terms subsidies to the European aerospace behemoth Airbus. Just hours later, the EU was preparing retaliatory tariffs on some $12 billion U.S. products.

Europe Bears the Brunt

According to Mody, the biggest impact from China’s slowdown will be in Europe, because trade is so important to the region. It’s being felt in Germany, which looks to be nearing a recession, he added. Italy already is in recession. With China slowing, the “sugar high” of tax breaks already wearing off in the U.S., and “Europe completely dependent on world trade … I’m not able to see what the major sources of growth are.” Mody suggested that the IMF forecast is too high, and “we may end this year closer to just 3% and therefore be in a somewhat dire situation, particularly in countries like Italy, which are very precariously balanced right now.”
Longer term, should growth in China slow to 3% to 3.5% a year, then world trade will drop to 2.5% to 3% annually. That is “catastrophically low” for EU countries.

“Italy will be in almost permanent recession, with its huge financial burdens. We have the making of a crisis…. [Right] now, I’m not quite clear how we can avoid that.” Mody noted that in his book, Euro Tragedy: A Drama in Nine Acts, “I call Italy the fault line in Europe. That fault line has been steadily deepening…. Italy is now in recession. My view is that it is now on the threshold of a financial crisis … and could get tipped over at any time.” If you drew a checklist of factors that cause a financial crisis, “Italy has all of them….” What’s more, various European safety nets designed to save Ireland and Greece are not adequate to help Italy, whose sovereign debt is similar in size to the debts of Germany and France.

Gomes added: “We live in a world where we’re getting older and productivity is slowing down…. If you take a 10 to 20-year outlook, we are going to slow down. That’s just a fact…. I think everything you see on the horizon is negative.” Gomes, like Mody, does not see any obvious sources of strong growth in the near term — certainly none with the strength to reverse the trend.

“The ECB (European Central Bank) has no room for monetary policy anymore,” Mody pointed out. “I think that is very important to understand…. In terms of the big possibility of monetary stimulus, it has nothing left to give anymore.” The same is true for fiscal policy, he adds.

Gomes agreed that Europe is the most vulnerable part of the world to recession right now. “The question is, how do you solve this? And really, none of us knows. That’s the honest truth.”

Dueling Popes? Maybe. Dueling Views in a Divided Church? Definitely.

Pope Francis, left, during a visit to Pope-emeritus Benedict XVI at his residence in the Vatican on Monday.

By Jason Horowitz

Pope Francis, left, during a visit to Pope-emeritus Benedict XVI at his residence in the Vatican on Monday.CreditCreditVatican Media

ROME — Pope Francis dropped in again this week on his predecessor, Pope emeritus Benedict XVI, wishing him happy birthday “with particular affection” in a now familiar showing of white-cloaked cordiality.

But behind the friendly visit, the talk of conspiracies and competing power centers is swirling inside the Vatican and far beyond. Just last week, Benedict, who turned 92 on Tuesday, released a 6,000-word letter holding forth on his views on the origins of the Roman Catholic Church’s clerical sex abuse crisis — effectively undercutting Francis on a contentious issue that has roiled his papacy.

For many church experts, the letter marked the most recent, and egregious, example of why having two popes — whose homes are separated by a few hundred meters but whose style, substance and visions of the church are vastly apart — can be so confusing to the faithful.

To be clear, Francis is the pope and is in charge. He is the one who can promulgate dogma and whose papal pronouncements when speaking “ex cathedra” — with the authority of the office — on questions of faith and morals are considered infallible. Benedict gave all that up — including the infallibility — when he stepped down. 
“What is happening is what many of us hoped would not happen,” said Massimo Faggioli, a professor of theology and religious studies at Villanova University, who is supportive of Francis. “The idea of a double papacy is really, really disruptive.”

Indeed, instead of creating concrete remedies for the scourge of sex abuse in the church, the letter has once again made the Vatican, always a gossipy royal court given to intrigues, rife with fresh rumor of rivalry.

Pope Francis and Prefect of the Papal Household, Georg Ganswein, during a weekly general audience at the Vatican in January.CreditTiziana Fabi/Agence France-Presse — Getty Images

Specifically, speculation has mounted that Benedict has been used as a stalking horse by conservative ideological opponents of Francis, whose more pastoral, inclusive and less dogmatic approach to the pontificate they consider destructive.

There has also been debate over whether Francis’ lieutenants blocked Benedict’s letter from being submitted to the church leaders gathered for February’s unprecedented summit on clerical sex abuse.

When Benedict in 2013 became the first pontiff since Gregory XII in 1415 to resign, his vow to stay “hidden to the world” seemed a guarantee that he would keep to his refurbished Vatican convent and stay out of his successor’s way.

That has not always been the case, fulfilling what scholars and faithful feared would be a potentially nightmarish scenario for a modern church already torn by ideological divisions, and largely unprepared for the tempests of real-time communication in a social media age.

When Benedict quit, it was unclear what he would call himself. Since the pope is also the bishop of Rome, some theologians suggested and expected that he would call himself “Bishop emeritus of Rome” to help clarify that there was only one pope at a time.

But even before the conclave that would elect Francis, Benedict announced that he would take the title “Pope emeritus.” It was a choice that confounded his critics and even some of his supporters.

Cardinal Gerhard Müller of Germany at a mass for a canonization celebrated by Pope Francis in St. Peter’s Square at the Vatican in 2015.CreditAlessandro Bianchi/Reuters

Archbishop Rino Fisichella, a respected Vatican theologian who advised Benedict and heads the Pontifical Council for Promoting New Evangelization, which Benedict created, said in 2017 that he respected the former pontiff’s choice but would not use the title.

“Theologically, it poses more problems than it resolves,” he said.

Benedict’s letter is the most recent example. Intended as notes for February’s major summit on sex abuse, Benedict delivered what many theologians considered an embarrassing analysis of the crisis of pedophilia within the church, blaming it on the sexual freedoms of the swinging 1960s.

Francis instead has frequently attributed the crisis to clericalism, a systemic abuse of power and the unhealthy pursuit of authority within the church’s hierarchy.

Benedict, however, had argued in his letter that “all-out sexual freedom” prompted a “mental collapse” that he linked to “a propensity for violence.”

“That is why sex films were no longer allowed on airplanes,” Benedict continued. “Because violence would break out among the small community of passengers.”

Archbishop Georg Gänswein, Benedict’s longtime personal secretary, who is also the prefect of the papal household under Pope Francis, confirmed that Pope Benedict wrote the missive “absolutely on his own.”

   Sex abuse survivors and their advocates marching in Rome in February.CreditAlessandra Tarantino/Associated Press

Benedict retains vast influence, especially because he was the church’s dominant theologian for more than three decades, first as John Paul II’s doctrinal watchdog and then as pope. He has the full allegiance of the traditionalists that he championed.

Among some of those formed by his teachings and elevated by him through the church ranks, the words of Benedict carry more weight even than those of Francis, a Jesuit whose tendency to speak off the cuff and emphasis on pastoral inclusiveness over church doctrine infuriates them.

“Throughout his brief text, Ratzinger has moments of insight and genius that fall like rain in a desert, especially today,” wrote Archbishop Charles J. Chaput of Philadelphia, a leading conservative who is often at odds with Francis. He added that in the face of so much moral erosion, “The good news is that some of our leaders still have the courage to speak the truth.”

Cardinal Gerhard Müller, whom Benedict made the church’s doctrinal watchdog, and whom Francis later fired, has also heralded the letter as good sense.

“They have welcomed the message as the truth, meaning the other is lies,” said Mr. Faggioli. “There are some Catholics who think Pope Francis is so bad, they believe it is better to flirt with schism.”

The Vatican has responded by seeking to emphasize the continuity between the two popes. The editorial director of the Vatican’s communications department, a former top Vatican reporter, Andrea Tornielli, argued that the responses of the two popes to the sexual abuse scandal was essentially “the same proposal.” He said that the letter had set off a “lively debate.”

Nuns walking through St. Peter’s Square in Vatican City last year.CreditSpencer Platt/Getty

In recent years, Benedict mostly bit his tongue and said “let us pray” when egged on by his conservative allies, who complained to him during visits and wanted him to speak out against Francis.

In private letters he wrote in November 2017 to a German cardinal, one of the public opponents of Francis, Benedict essentially reprimanded the cardinal to knock it off for risk of devaluing his own entire papacy and having it “conflated with the sadness about the situation of the church today.”

But the letter on sex abuse marked a change. While Benedict got permission from Francis to write his letter, which he intended for a tiny journal for German priests, a right-wing Catholic media complex that is funded by critics of Francis and often works in concert was primed to amplify Benedict’s message.

The Catholic News Agency, which is owned by the United States-based Eternal Word Television Network, a frequent theater for critics of Francis, posted a full and meticulous English translation of Benedict’s letter online in the early hours of April 10. Other conservative outlets were also provided the letter.

Sohrab Ahmari, a contributor to the conservative Catholic Herald, wrote on Twitter that he “broke this story worldwide” in the New York Post, where he is the op-ed editor. He declined to say how he got the letter.

Archbishop Gänswein declined to comment when asked if he provided the pope’s address to the conservative media, as many supporters of Francis suspect.

For many traditionalist and conservative Catholics, who believe Francis has sown confusion by drifting from orthodoxy, the mystery was not how the letter appeared in conservative outlets around the world all at once, but why it wasn’t submitted, as Benedict apparently intended, as a contribution to Francis’ extraordinary summit of church leaders to discuss abuse in February.

“Why wasn’t it given to the bishops at the summit,” said Marco Tosatti, a Vatican journalist who this summer helped the Vatican’s former ambassador to the United States, Archbishop Carlo Maria Viganò, compose a letter that called for the resignation of Pope Francis. “That is the real question.”