Lately with trade disputes ratcheting up, I’ve had a lot of questions about the impact of trade uncertainty on market actors and businesses, including whether markets are overpricing risks given the strength of global growth. The jury’s still out, particularly as we’ve been in an as good as it gets moment, but the results don’t look great looking ahead. Trade policy uncertainty by making supply chain costs harder to predict may reinforce what was likely to be a cyclical slowdown in 2019/2020.

I’ve been concerned for some time that trade uncertainty would make it harder for businesses and indeed households who likely bear the brunt of cost volatility to plan. FX would likely be a major vector of transmission , but uncertainty about supply chain costs, might exacerbate the impact of the tightening of global liquidity implied by the exit of central banks from super-accommodative policies.

I’m not suggesting that trade barriers are the only or even primary driver of decisions, but uncertainty might cause some businesses to hold off on making investments that were already iffy. It might also increase a trend towards deepening of domestic supply chains, which would shift some of the winners and losers in the global economy. Finally it might add to the trend of more consumption rather than investment driven global growth. This seemed a particular risk for countries such as Canada, that are very exposed to U.S. markets, and where the central bank has been concerned that trade uncertainty might be adding to already sluggish business investment.

Perhaps its no surprise that one of the more interesting recent pieces on the role of trade uncertainty comes from a Canadian institution  Meredith Crowley and Dan Ciuriak make an important addition in Weaponizing Uncertainty which does a nice job summarizing recent episodes of uncertainty, vectors of transmission and highlighting ways in which uncertainty on its own might pose a new non-tariff barrier.

One of the biggest questions of the last few years has been when/if trade policy uncertainty might impact global and U.S. growth (see my podcast with hidden forces for a detailed discussion). We may be reaching that time, more so outside the U.S. the U.S. than inside it due to regulatory choices, and fiscal trends, however, U.S. consumers and businesses will be on the receving end of blowback also. Remember, than sizeable earnings of the S&P 500 are from foreign profits.

US policy trends
Recent framing of the U.S. numbers suggest that fiscal stimulus is prompting more of an impact on growth and providing a cushion for administration officials, but doing so is supporting imports, making it even harder for the administration to meet its self-imposed trade deficit goals. Moreover the impact on the USD raises some real questions about dollar funding, especially as the US government has increased its issuance in the market, putting pressure on competitors, exactly as the central bank bid is easing or reversing. This suggests that assessing fundamentals will be important, with weaker fundamental countries and companies providing support.

Chinese response: Could it be easing?
As I’ve noted in past pieces, Chinese policy response is critical to the global outlook, the performance of assets and the transmission. the Chinese policy response shifted form a moderately supportive one (monetary, credit) to a more neutral and slightly tighter one over the last year, amplifying the impact of a relatively tighter fiscal stance. The PBoC balance sheet is now expanding at a slower pace (as local exposures offset for lower foreign currency holdings). The output data from Q2 so far show a cyclical slowdown on the investment side, though not on the retail side. the natural reaction of the Chinese authorities would likely to be to take a slightly easier, stance particularly if they were worried about tightening from the U.S. and supply chain disruptions. This would have the side “benefit” of allowing the CNY to reverse recent appreciation against the basket. The question will come if the CNY starts weakening beyond the basket. 

Note that I think market and policy chatter about the possibility that the Chinese might sell their holdings as relatively ridiculous. While China has been looking for opportunities to diversify the portfolio and aims at shifting the currency risk to non-Chinese actors, a political decision to sell their treasurys would have several detrimental impacts

• increased uncertainty, domestically and abroad including challenges continuing to absorb debt and equity flows. 
• capital losses, especially as its difficult to unload quickly. 
• CNY appreciation vs USD. The last thing Chinese authorities would want is a significant appreciation, suggesting that they may be opportunistic and finance private capital outflows but are unlikely to impose a policy.

If the policy stance does turn easier, and depreciation pressure materializes, this poses a challenge for authorities as it might be difficult to fully control. This suggests moral suasion and domestic policies might be used to limit repatriation. Indeed non-tariff barriers, and even some economic coercion for political aims (core interests such as Taiwan and south China sea) may start to move up again. See my colleagues at CNAS for more on some possible moves.
Are we headed for another crisis? 
Several recent reports (UNCTAD, World Bank) put emphasis on policy uncertainty in reducing long-term investments. I’m not sure trade protectionism can take the full blame here, though it may complicate things. 

Domestic Policy uncertainty around fiscal policy, domestic prices and utility tariffs or infrastructure caps investment in Brazil (though recent IIF analysis on FDI suggests that risk may be overstated) as does expropriation risk in Russia, Saudi Arabia etc. these can add up. in general we have seen much more portfolio debt flows than equity and more short term than greenfield or even brownfield investment. This reflects questions on the business environment at home as well as demand at home and abroad.

I was asked a few weeks ago about worries that trade protectionism would lead to a 2008 like recession. That’s always possible, but I find it hard to see the vector for such a sharp contraction in credit and inability to access global demand. Major tariffs would likely be absorbed through Fx swings and some short Fx positions in usd would be stopped out but I don’t see as much shadow banking risk or collapse in counterparty risk. That’s not to see Macro outlook would be great under a tit for tat trade environment between us and China but the outcome might be more gradual. Key to watch is the policy moves of the Chinese government, especially given the sizeable increase in debt and continued quality of growth issues. 
I think there is likely to be a modest drag to business investment outside the United States particularly in the Americas and Europe and some higher cost Asian producers. This is because the tariffs reinforce some other concerns about final demand- and on the margins tax measures have made it somewhat cheaper to locate operations (finance, services) in the us.
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Then what tariffs matter a lot. Steel and aluminum tariffs will add to inflation and have a modest growth drag, but pretty limited and even nafta withdrawal will only somewhat disruptive in the near term with greater impacts in the medium term. I would be more concerned about the impact of sizeable tariffs on Chinese trade which would have greater impact on global supply chains including a drag of up to a percentage point on us growth and more on some of its trading partners. This is a major reason why it may not get implemented in full. Along the way, it will be harder to plan and financial and other investors may remain more wary. Coupled with concerns about current valuations, justifiying current P/Es looks difficult.
More to come.

Last week, OPEC+ ministers managed to come to a consensus after days of contentious discussions in Vienna, achieving the goal of formally keeping the OPEC+ alliance together, but failing to solve some of the thorny issues between key members including Saudi Arabia and Iran. The final agreement, which commits the group to reversing recent overcompliance to boost production, remains formally agnostic on who will contribute to that production increase.  This post looks at the factors that will shape upcoming fundamental outlook and assesses the macro impact for some key producers.

This suggests the alliance has moved into a transition phase of exit and shift to a different and more contested data dependent mode.  The time-buying (or can-kicking) deal allows for more time to assess several key supply and demand variables described below including the impact of sanctions, the politically driven pressures and the resilience of global consumers.

In the near-term, the results support higher prices, especially as the net addition of fuel will be modest, and the result of individual decisions not the collective. Meanwhile the looming implementation of Iran sanctions poses a risk.  Additions from the countries which can add  will likely to offset by continued Iranian export declines  as businesses trim their imports ahead of key November sanctions dates. The uncertainty around supply and risk of unilateral action to make up the gap. increases the likelihood of volatility and production.

Overall the result mapped with my expectations of gradualism, a moderate increase now, with ongoing reassessment  and eventual gains through the year. As noted in our coverage of the Iran deal exit, OPEC members were likely to add supplies slower and more modestly than some market actors expected, while bargaining and price discounting from the Iranians would complicate assessment of production. The political pressures and uncertainty on production outlook in several key countries (including Venezuela, Iran, Libya, Nigeria), make it hard to imagine a different outcome, but divides will build over time, as further outages build in countries like Iran and Venezuela and only a few countries can produce more in compensation.

Focus on the big alliance, not only the smaller ones within OPEC: The result highlights the importance for Saudi Arabia (and GCC allies) as well as Russia of retaining the alliance struck in 2016 on managing oil output. Remaining vague on the details of how the production will be re-allocated from Venezuela to the countries with spare capacity, avoids a political decision that will eventually need to be addressed, since its hard to see any meaningful increases from that country. In fact, output is likely to fall further due to strikes, job cuts and equipment seizures.
Gradualism allows for more information gathering:  By later in the fall, there should be more clarity on the following relevant fundamental issues that make it currently difficult to plan.

• Iranian production and sanctions regime: Already, businesses (shipping companies, refiners and others) are chosing to pare their purchases of Iranian crude oil, looking to made some reductions that hedge their bets against U.S. requirements to significantly reduce purchases. These decisions reflect both concerns about sanctions implementation but also ongoing negotiations on price between Iran and its buyers. Details on how OFAC will implement waivers remain to be announced, suggesting that buyers are assuming continuity with the last administrations definition of “significant reductions” implying a 50% drop every six months.
• Other outages including continued implosion of the Venezuelan oil industry and broader economy as well as outages in Libya, Nigeria and elsewhere.
• Shale production and infrastructure: Rig counts, output and other metrics suggest oil production is increasing in the U.S. and will continue to do so. However, there continue to be bottlenecks getting the fuel to global markets (keeping the WTI and Brent spreads wide) and costs are increasing in the shale patch. The additions from the U.S. will be supportive of U.S. growth and the energy trade balance, but are unlikely to be enough to offset for other losses, particularly in the medium-term.
• Demand resilience in the face of higher than 2016/7 prices. Most assumptions posit continued oil demand growth due to resilient global demand and growth. Two factors increase the risk that the pace of demand growth will weaken – the increase in local cost of fuel to the end user in local currency and the risk of weaker global growth due to the moderation of the cyclical expansion, something that could be exacerbated by the increase in trade protectionism that is tempering the outlook for fixed investment. The composition of global growth, more linked to consumption (and thus transport fuels) provides some resilience to oil producers, but the pace of demand growth still may slow. By Q4, we should have a better sense if higher prices are tempering demand for fuel or other goods, making it easier to assess. Even before that individual countries may decide to pump more if key buyers (India, China among others) demand.

More data on each of these points will be key to the next phase of the alliance.

Exit from easing needs new forward guidance. 2018 was always going to be the year when the alliance shifted to a new phase. Like global central banks moving to quantitative tightening, the alliance (which was in a formal tightening phase), will employ new forward guidance for easing. The Joint monitoring committee (and a range of private monitoring bodies, are likely to take on a bigger role with focus moving beyond 5 year inventories as their main fundamental metric. It remains unclear what the new metrics, and forward guidance will look like. Saudi Arabian officials have already gone on the record to highlight the need for well over 1 million barrels a day in increase by the end of the year. Doing so, while absorbing Iranian output is likely to be difficult.

What might the impacts be on oil producers?
The decision brings increased breathing space to most oil producers, especially Saudi Arabia, most of the rest of the GCC and Russia, which account for the bulk of global spare capacity. While prices might soften from their recent levels,  the increase in output, even if moderate should keep oil revenues elevated compared to 2017 levels and increase the energy contribution to growth. This should modestly reduce oil fiscal breakevens, though we assume that most countries will take the opportunity to spend a little more given that non-oil growth has been sluggish especially in MENA and SSA.

Our analysis suggests more GCC countries will use this space to become a little more expansive on the fiscal side, offsetting for what continues to be sluggish private sector growth, credit and sentiment. We have already seen stimulus rolled out in Abu Dhabi and Qatar,  and spending outpace plans in Saudi Arabia, though some of these look temporary. We assume that fiscal breakeven price in Saudi Arabia may fall slightly to the low/mid 80s from the current $89/barrel, suggesting slightly less draw on debt. This implies that there will be more final demand rather than petrodollar savings. Countries in a position to save more include UAE (Abu Dhabi), Kuwait, Qatar, Russia, Kazakhstan, and possibly Nigeria. The chart below highlights likely shift in the current account surplus (flow of savings net of imports of goods and capital).

Other countries including Oman, Saudi Arabia, Iraq will likely tend to borrow less or draw down fewer reserves. Saudi Arabia likely will have more pump priming space to support the private sector.

We see a modest increase in Russian output, but limited impact on growth. In Russia, the flexibility of the exchange rate remains a key adjustment tool and increase in output is an offset to the financial cost of sanctions.

Those most vulnerable remain Venezuela, where local mismanagement, asset seizures and the exacerbating impact of sanctions suggest significant further outages. While politically OPEC could not formally reallocate its target, its hard to see any reversal of outages, especially as recent legal cases and strikes undermine its capacity further.
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Iran, too will start to feel the pinch from the drop in oil prices, with the full impact dependent on sanctions implementation. For more on the scenarios, please see here. Decisions on adjusting to Iranian outages are more likely to be bilateral (between buyers and sellers) than within the alliance, but its hard to see if able to sell its current targets.

It is now the time of mid-year reviews, so I thought a little recap was warranted. Recent Market action provides a good time to reassess some of the drivers of global growth and returns going into the second half of the year and look ahead to 2019. Key questions remains about the macro damage from rising rates and selected capital outflows, rising oil prices and especially trade conflict. All of these trends but especially trade uncertainty are likely to reinforce a cyclical moderation of growth globally (returning closer to potential). This post highlights a few key assumptions and the catalysts I’m watching in the coming weeks to help identify opportunities and risks going forward.

Bottom line: global economic and trade growth are likely to slow in 2019, weighing on equity valuations, especially once the one-off payoffs to investors are completed. Stronger energy prices bring winners and losers, within and between countries, suggesting some outperformance of oil-linked FX and equities. Core interest rates should edge up in a non-linear way, as global central banks stick to their plans in the face of greater issuance. This should provide select opportunities for stronger countries. Among regions, Latin America should continue to lag, as the capital outflow pressure dampens the recovery, while Asian countries look more resilient to higher interest rates.
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In this post, I  look in more depth at

• Trade scenarios: Best case looks to be a continued rollercoaster which makes planning difficult, bringing a modest drag on growth, rather than a more meaningful one.  A deal with China or something proclaimed as one still seems likely, but broader U.S. macro policy (fiscal) and recent market correction make closing the trade gap even harder.
• Global Monetary Policy: softening from selected EM and peripheral risks is unlikely to be enough to shift the global central bank trajectory – slowly tightening
• Europe: Peripheral risks are likely to recur, but ECB exit may not be under-anticipated. These developments may reinforce cyclical weakening.
• China: Policy settings still relatively supportive, limiting slowdown of global economy. No signs of major deleveraging.
• Energy outlook: Key questions remain about likely readjustment of OPEC+ output, which are likely to add volatility in the near-term and depress North American blends. Higher prices are likely to dent but not reverse demand growth. OPEC+ may wait to see how much Iranian oil can be displaced suggesting a more gradualist approach.
• EM pressure: EM Flows are likely to remain differentiated, higher rates likely to keep Latin America from much of a growth revival, and Asian countries more resilient despite the commodity rally. Oil-linked countries should receive some respite, led by government spending.

Trade rollercoaster to continue: Tariffs and threats complicate investment.  
The U.S. trade policy trajectory remains a major risk to market sentiment, a trend that’s unlikely to end any time soon. That U.S. policy shifted from mere rhetorical threats to more specific ones is no surprise, but the ultimate goal of what would be deemed a success remains unclear, aside from the goal of reducing the trade surplus, something that other macro choices at home and abroad (fiscal and monetary) make more difficult. While the U.S. may strike some mercantilist deals, including with China, I would anticipate that the trade policy risks will linger well into 2019, undermining corporations ability to make decisions. So what are the key scenarios?
The tariff announcements have come fast and furious from the U.S. followed by lists of possible retaliation targets from trading partners. The tariff threats intersect with and are designed to crystallize attention on ongoing coercive trade negotiations, where the aim seems focused on reducing the U.S. trade deficit, rather than necessarily any measures on improving the quality of growth. In this way there is a risk that This trade and investment rollercoaster is likely to continue through the fall and possibly into next year, raising risks of price increases and just making it harder for businesses to plan.
At this point, there seem to be two key scenarios

• a base case in which there is continued uncertainty and modest tariff application, that adds moderate costs through the supply chains and makes it harder to assess profits, but which lacks broad-based trade restrictions. In this scenario, businesses find it harder to plan, deferring some investments, especially if other domestic policies foster greater uncertainty. In this scenario I’d expect some mercantilist deals, perhaps tied to security policy goals, but lingering restrictions in key areas. China and NAFTA remain the key negotiations to watch, with some temporary agreement likely with the latter.
• A second, worse scenario, would involve greater volume of trade being effected, and price increases hitting demand and leading to temporary supply shortages. Tariff implementation would likely add to FX volatility as that would likely be the primary transmission chain.
• Note that a third scenario of a positive feedback loop from moderate, modernizing trade policies seems less likely at this point. In this scenario, trade policy might be neutral to positive, with broader monetary and fiscal policy providing a bigger driver to growth.

Countries and sectors heavily reliant on trade, especially with the U.S. as end buyers including parts of South East Asia, Korea, as well as Canada and Mexico, would likely to face more vulnerability, though currency adjustment to the tariffs might alleviate volume declines.
European Risks: Peripheral risks to stay active, but not sway ECB
Italy’s deadlocked cabinet formation and some less problematic politics in spain led their yields to recent heights and reignited concerns about a euro-exit. This still remains unlikely any time soon, but the lack of growth in Italy and an unsustainable debt burden suggests that there are no easy political solutions. On net, the rising costs (partly a function of the ECB steps towards tapering which allow market actors to look more closely at fundamentals) are likely to increase savings rates in Europe, especially if more austerity is mandated. In the last half decade, debt profiles of peripheral countries have become more concentrated nationally, which makes addressing this issues harder.
Europe was headed towards a cyclical moderation of growth after over potential growth for parts of the core over the recent period. Overall macro trends are likely to keep ECB on course, which will in turn gradually bring more focus on the fundamentals of the credit profile.
The transatlantic divides don’t help of course with both the trade risks and the implementation of sanctions on Iran (and to a lesser extent Russia) complicating matters within the zone by increasing divides. For example, Italy, France and Greece are among the most exposed to Iranian crude, and include some of the more energy intensive countries. By contrast Germany and CEE are more exposed to U.S. tariffs directly (small) or via diversion from China. Expect more of these macro and security policies to remain linked.
Emerging Market pressure: Differentiation likely but borrowing costs edging up
The reversal of some of the extensive capital flows is likely to drive differentiation across the EM space, with oil producers outperforming, along with those with manageable inflation outlooks, and external surpluses. Growth is likely to slow sharply or fail to recover in a few most afflicted countries, forcing external deficits to narrow (Turkey, Argentina), but central bank responses are likely to selectively revive the carry trade. I don’t see a major drag on global growth, but rather a limited growth acceleration.
In aggregate, EM have experienced capital outflows from equity and bonds, and most FX have weakened. However the selloff this year has been highly concentrated in a few countries – Turkey, Argentina, Brazil and to a lesser extent sanctioned Russia. All three have meaningful policy vulnerabilities that investors only remembered when U.S. yields began rising – including external imbalances (Turkey, Argentina), wide or widening fiscal or quasi fiscal spending (all three), policy uncertainty post 2018 elections (Turkey, Brazil). CEE countries, which previously benefited from the ECB bid to reduce yields, have also suffered more than in the taper tantrum.
By contrast many Asian FX have been more resilient – notably India and Indonesia, partly because they reduced short-term FX liabilities, and central banks have been responsive. On the margins the end of most EM monetary easing will constitute a modest drag on growth, but not a major one. Chinese policy is key to assessing the broader response – the focus on selective small corporate defaults and limited deleveraging, and extensive overall credit is likely to keep underlying demand decent.
As mentioned in last month’s EM Q&A, I don’t see a lot of pegs to break, a difference from past crises. Most of the lingering pegs and quasi-pegs remain among oil producers, and the improvement in trade outlook is likely to reduce pressure compared to the last two years. In fact countries like Nigeria would arguably have an appreciating currency. GCC pegs even invulnerable Bahrain and Oman, look much more manageable than even six months ago.
Oil Rebalancing: OPEC+ actions Bring Volatility and New Price Band.
The OPEC+ group cuts and desire for profits among shale producers have brought the oil market closer to balance, helped by massive economic implosion in Venezuela which has led the broader group to overcomply with cuts, boosting prices, especially of Brent and products. The increase risks denting but not reversing demand growth including from key emerging markets.
Logistics issues are likely to limit the ability of North American producers to take full advantage of this demand and price dynamic, keeping the WTI-Brent and other discounts like Western Canada select weaker, even as production costs begin to increase. Production will continue to increase, but so will backlogs and some production costs.
This months OPEC meeting and seminar is a key catalyst to watch. Markets are expecting some increase in production, at least to take the group back to compliance not over compliance and possibly to net increase as demand has picked up more than expected. Key questions include whether the producers group will

• focus on reallocating among existing producers,
• increase overall targets
• avoid an increase but look the other way as key producers increase (Saudi Arabia, Russia, UAE, Kuwait are some of the few with notable spare capacity)

At this point, expectations of new additions of up to 1mbd may be overly optimistic and may only follow actual cuts to Iranian oil (see my recent piece for more on the Iran elements)
Beyond OPEC, two Latam countries, Brazil and Mexico have elections that might be key to energy production going forward. Both Brazil and Mexico are net importers of hydrocarbons meaning they are buffeted on both sides by oil price volatility. While an AMLO government is unlikely to have the margin to be able to reverse reforms there are some policies that might slowdown new developments. Brazil’s strike of recent weeks, highlights some of the challenges in passing on higher costs to end users. I’m not optimistic about the ability of Brazil’s new government to maneuver both their fiscal adjustment and new infrastructure investment. The country has been a source of under performance on the supply side.  Watching not only election results, which may be deadlocked, especially with congress, but also new leadership of Petrobras will be important.