August is upon us and lingering issues are heating up, with the potential to impact markets during the second half. Below, I recap three important events from last week and highlight four key issues to watch in August.
U.S. job growth was solid but unspectacular for July
The U.S. Employment Situation Report for July was released last week. Here are the key takeaways:1
Nonfarm payroll growth clearly underwhelmed at 157,000. However, we need to remember that one month does not a trend make; in the midst of this impressive jobs recovery, we’ve seen even more anemic payroll numbers in certain months. For example, March 2017 nonfarm payroll growth was just 79,000 (after being revised downward). And keep in mind that two previous months’ nonfarm payrolls were revised upward
Far more important than nonfarm payrolls or the unemployment rate is wage growth – the most important metric, in my view. Average hourly earnings remained a tepid 2.7%. However, higher-paying sectors such as manufacturing and construction, and professional and business services added a significant number of jobs, continuing a recent trend. This suggests that, at some point, we should see stronger wage growth. However, we also need to recognize that areas like manufacturing are vulnerable to tariffs and/or a strong dollar, so we will need to follow the situation closely
This jobs report has no impact on my views on Federal Reserve (Fed) rate hikes. I firmly believe that a Fed rate hike in September is a done deal, and that a fourth rate hike this year is definitely not a done deal. While a fourth rate hike could certainly occur in 2018, I believe that is still to be determined. A lot can happen in the next few months, especially with regards to trade policy and its impact on the economy.
The Bank of England raises rates despite Brexit uncertainty
The Bank of England (BOE) made the controversial decision to raise rates last week. While BOE Governor Mark Carney said that further rate hikes would be “gradual” and “limited,” the decision to raise rates was criticized by some members of the business community because of all the uncertainty around Brexit. Their concerns are valid, in my view, and were underscored by Carney admitting in a recent BBC interview that the odds of a no-deal Brexit are “uncomfortably high” and that a no-deal Brexit was “highly undesirable” – which could go down in history as the understatement of the year. However, I believe the growing likelihood of a no-deal Brexit may have actually prompted the BOE to raise rates – after all, it arguably needs some dry powder if this comes to fruition.
The Bank of Japan adopts a more flexible monetary policy
The Bank of Japan (BOJ) made some small alterations to its approach to monetary policy last week. It announced it will adopt forward guidance for policy rates with the goal of enhancing the sustainability of its easing measures. The BOJ said that it would conduct its bond-buying program flexibly, and that long-term interest rates could fluctuate as a result of economic and price developments.
In addition, the BOJ plans to conduct its asset purchases more adaptably: The BOJ can increase or decrease the amount of its exchange-traded fund (ETF) and real estate investment trust (REIT) purchases in order to have more flexibility. From my perspective, this is emblematic of the difficult position the BOJ finds itself in: It has a complex monetary policy framework, it seems trapped into continuing with its current level of asset purchases, and it needs to prepare for the negative effects of the consumption tax hike planned for October 2019. In order to help support its domestic stock market and be better able to handle issues as they arise, the BOJ has injected some level of flexibility into its approach – as best as can be given its predicament.
Four issues to watch in August:
1. The yuan. The yuan has been falling significantly in recent weeks, and that drop continued for much of last week. Not only has the People’s Bank of China (PBOC) cut rates multiple times over the past eight months, but there are clearly concerns about the economic outlook for China – both of these trends have placed downward pressure on the yuan. However, the yuan has experienced a relatively modest rebound in the last few days. That’s because the PBOC announced a tweak to its monetary policy that helped strengthen the country’s currency: Traders are now required to place reserves equal to 20% of their position in some foreign-exchange forward contracts – making it a lot more expensive to short the yuan.
In addition, it appears that China has hit the “pause” button on deleveraging, with President Xi Jinping committing last week to a package of pro-growth measures including higher government spending – which should be especially impactful in areas like infrastructure – and easier credit for banks and businesses. Going forward, I expect pro-growth measures (including upcoming tax cuts for individuals that are planned for this fall) to improve the economic outlook for China, which in turn supports the yuan. However, it appears that China will also attempt to keep its currency relatively weak in order to support trade in the face of rising tariffs – which should result in something of a tug-of-war that could cause the currency to fluctuate. That is not a “weaponization” of the yuan, although I would not rule out such a development if trade wars between the U.S. and China were to escalate further.
2. Brexit talks. Talks resume in mid-August in Brussels, and it is becoming increasingly likely that the UK could leave the EU with no deal, as several government officials are becoming more vocal and transparent about the dire situation the UK finds itself in. UK International Trade Secretary Liam Fox recently admitted that there is now a 60% chance that there will be a no-deal Brexit.2 Remember that the real deadline for the UK is not next March but this coming October, given the amount of time needed to have all member countries of the EU ratify the agreement. In other words, there is the potential for significant disruption in UK financial markets as we enter a high stakes period for negotiations. The pound is already at an 11-month low but could easily move much lower if it becomes even more likely there is no deal. We will want to follow the situation closely.
3. NAFTA negotiations. After blowing through the May 2018 deadline, leaving diminished hopes for a viable deal in 2018, North American Free Trade Agreement (NAFTA) negotiations have experienced a resurgence recently. It is being reported that the U.S. and Mexico are moving closer to an agreement on how to rewrite portions of NAFTA, although Canada has been excluded from these recent talks. The U.S. administration is keen on negotiating bilateral agreements, but Mexico is insisting that Canada be part of the final agreement, which would be a good thing, in my view. We will want to follow this situation closely, as there is a growing possibility that a new NAFTA deal is successfully agreed upon by all three countries.
4. The worsening U.S.-China trade situation. Last week, the Sino-American trade threats worsened. China has made it clear that it is not backing down, and I believe its decision last week to pursue a more pro-growth agenda is evidence that it is hunkering down and preparing for a fight.
China appears willing to experience short-term pain even though its economy has already modestly decelerated – and it is clearly far better able to play a long game than the U.S. It’s worth noting that the U.S. trade deficit increased in June – that may embolden the Trump administration to get more aggressive in its trade policy stance. As I’ve said before, if there is an escalation in this war, I would expect damage on both sides – although I disagree with conventional wisdom which suggests China would experience more damage. What’s clear is that this threatens to hurt the global economy, and so we need to follow the situation closely.