The new economic disorder

Published at 15:15 9 Aug 2019 by . Last edited 11:18 22 Aug 2019.

Due to the summer holiday period, there will be no Macro Digest next week. The next Macro Digest will be published on 23 August.

Risk assets got a boost late this week. The rally was driven by a market perception that the People's Bank of China (PBoC) is trying to stabilise the yuan rather than further devalue it. Meanwhile, crude responded to some timely jawboning from an unnamed Saudi official, leading to an impressive bounce in oil prices.

The remarks from the unnamed Saudi official implied that the Kingdom was about to rally support from the rest of OPEC for further cuts to oil production to try and stem the price decline. However, since the weakness in oil prices is mostly demand driven and a function of the deepening conflict between China and the US, it is unclear what the Saudis could do to boost sentiment. It could be argued that there is no need for another price signal from the physical market as all the benchmarks are in varying degrees of backwardation, crude differentials remain firm, and margins globally remain strong. Stocks in the US, Japan and ARA have now drawn almost the entirety of what was built in the spring, while forecasts for US crude production are being revised lower following a very disappointing earnings season. Saudi options here are limited.

Fig 1: S&P 500 vs VIX volatility index, pts Fig 2: Cumulative US, Japan & ARA stocks, mb
Source: Bloomberg, Energy Aspects Source: EIA, Bloomberg, PAJ, Energy Aspects

But if the Saudis really wanted to do something to boost prices, they would offer to mediate between Presidents Donald Trump and Xi Jinping to find some reasonable middle ground that would stop this escalation between the two largest economies in the world. There is no doubt that deterioration in global trade is accelerating the global economic slowdown, which risks tipping the world into recession, if it is not already there (we are looking at you Germany). But what we do know is that uncertainty surrounding trade is eroding confidence in the sustainability of demand growth in 2020 and potentially beyond.

Markets feared the worst early in the week as China’s PBoC allowed for a small, symbolic weakening of its currency, a clear shot across America’s bow in response to Trump’s threat to add additional tariffs (see Macro Digest: Oops he did it again, 2 August 2019). The last time the PBoC allowed a slight weakening of its currency was in 2015, when it then lost control of the currency as capital flight ensued.

The turnaround in global risk assets, what we are calling the ‘sigh of relief rally’, was driven by a market perception that the PBoC was stepping in to stabilise the currency rather than weaken it. The PBoC on Wednesday set the yuan midpoint at 7.0039 per dollar, just above the 7 yuan per dollar rate that markets had believed to be the proverbial ‘line in the sand’. However, 7.0039 yuan per dollar was lower than market expectations, despite being the weakest official yuan rate since April 2008. This was enough to trigger a strong recovery in the S&P 500, which spilled over and helped lift global equities and most other risk assets, including oil. Perception can sometimes, especially in trading, be as important as reality. But late on Thursday evening (8 August), the PBoC weakened the Yuan's fixing to 7.0136 per dollar.

Are the markets out of the woods? Hardly. The challenge for investors has not gone away, and the same uncertainties that prevailed early in the week remain. If anything, we think the market continues to underestimate the risks of a further deterioration in US-China relations.

Size matters
In many ways, the fears of rapid yuan deterioration were overblown. It is clear that the depreciation this week by the PBoC was meant to send a signal to Trump not to follow through on his latest tariff threat. Chinese officials believe that the imposition of 10% tariffs across the board can be offset by a 5% depreciation in the yuan. The problem for Chinese monetary officials comes if Trump were to increase tariffs to 25% as depreciating the yuan enough to offset such a large amount would be problematic for the PBoC. First and foremost, China needs to import capital given the country’s very narrow surpluses. China needs to attract capital and, in particular, dollars. If the yuan is weaker, it becomes increasingly difficult to do that. Ironically, China is in fact a currency manipulator, as the US treasury has accused it of being. However, China has actually been intervening to support its currency to keep it from depreciating, rather than trying to weaken at as Trump keeps saying. China is short dollars and it needs more.

Furthermore, a rapid depreciation of the yuan would create a public panic and the PBoC would struggle to contain the exodus of capital, much like in 2015, despite tighter capital controls today. The Chinese public would move quickly to shift savings into dollars at the first hint of a material devaluation of the yuan. We would hesitate to even call a meaningful yuan depreciation China's ‘nuclear option’, as the collateral damage from a steep depreciation may be too great. However, as demonstrated this week, China is prepared to depreciate tactically and gradually, and this will be a source of risk that stays with markets for some time.

To what end?
While there are bigger goals related to the broader relationship between the US and China, the question markets care about most in the near term is exactly what is the endgame for both sides in these negotiations? The endgame for Xi is quite clear—he wants US tariffs removed. But at the same time, he is unwilling to compromise on core areas to achieve that. In fact, as made clear by developments this summer, China is willing to take the pain now if need be and is taking a much longer view than the Trump administration.

For Trump, the end game is less clear. Perhaps the mischaracterisation of this conflict as one predominantly over trade has done a disservice to the market, which is still struggling to frame it. For the US establishment, this was never about soybeans. But for Trump, to some extent, it was about soybeans. And on this score, the recent Chinese counteroffer in Shanghai fell woefully short. The US negotiating team returned from the meeting in Shanghai having not secured commitments from China. Instead, the Chinese side said they would only buy enough agriculture products to satisfy their own demand and, notably, within their WTO commitments. This last bit in particular suggested to the US team that China would not buy in the volume which Washington had hoped. There were also more Chinese demands surrounding Huawei.

Despite the escalation, so far neither side has pulled out or cancelled the talks scheduled for later this month in Washington. In many ways, the ball is now in Trump’s hands and his next move will likely decide whether this escalates aggressively or if there is scope for yet another ‘tactical pause’ between the two countries. We may get a glimpse of Trump’s intentions on 19 August, which is when the temporary licenses issued to Huawei in May are set to expire. Whether Trump agrees to extend the licenses or not will be an important signal for markets. In May, the Trump administration added Huawei technologies to the Department of Commerce’s Entity List, which prohibits the sale or transfer of US technology to companies or persons on the list unless a special license is issued by the Bureau of Industry and Security (BIS). Should the Department of Commerce not renew Huawei’s general temporary license by 19 August, then the company will not be able to support many of its existing products. The Chinese are demanding that all restrictions on Huawei be lifted as part of any agreement.

There are currently big divisions between the John Bolton hawks in Commerce, who are true believers, and the Wilbur Ross crowd, who are pragmatists. Trump will likely have to intervene and make the decision. There is no real anchor to the Xi-Trump relationship, so it is very tough to measure. For the Chinese, Trump needs to extend the general license for Huawei at a minimum. The Chinese would deem non-renewal as a hostile step. There is potential for a limited deal here that would result in some Chinese purchases of US agricultural goods in exchange for Trump extending the Huawei licenses. While it may not be the deal Trump wanted, it seems to be the only deal that China is willing to accept. But for Trump, this may not be enough.

Love the one you are with
If the Chinese authorities are hoping that any of the Democratic candidates would be easier to deal with than Trump, they may be in for a shock. First and foremost, there are many Democrats who are more hawkish than Trump on China. Trump has made several policy missteps that have made confronting China more difficult, namely trying to do this alone by leaving the Trans-Pacific Partnership (TPP), negotiating impulsively via Twitter, and using tariffs as a blunt weapon to try and bludgeon the Chinese into submission. A Democratic president could perhaps manage to bring together a multilateral coalition that could present a united front on the core issues that matter to many other countries and not just the US. In that sense, China may be better off doing a deal with Trump.

Whereas the relationship between the US and China for the last 25 or so years has been defined by cooperation, going forward it will increasingly be defined by competition. Breaking up is hard, and the market is still trying to wrap its head around what that means for trade flows, global growth and demand.

The Outlook
Brent: Flat price bounced impressively this week following verbal intervention by the Saudis suggesting that the Kingdom will do ‘whatever it takes’ to support oil prices. In general, comments from unnamed Saudi sources should always be taken with a grain of salt. If it was policy, the minister would have said it publicly. But even the intervention itself was botched, with the Saudis claiming that production in September would be 0.7 mb/d lower than nominations, suggesting that the Kingdom is withholding crude from the market. But of course, that does not guarantee that September production volumes will be lower than those in August. In essence, the Saudis are suggesting phantom cuts. Just what the market needs. We do not expect the Saudis to unilaterally cut production further, nor do we sense any appetite on the part of other members of the OPEC+ for deeper cuts.

It was notable to us that prices this week fell to within spitting distance of the Q4 18 low of 50 dollars per barrel. Back then, the crude oil market was grossly oversupplied following the massive ramp up in Saudi and Russian production. The physical markets were extremely weak, with most of the benchmarks in varying degrees of contango. Prices have now fallen again, but this time the physical market situation stands in sharp contrast to Q4 18. The crude benchmarks are backward and physical grades remain well bid. It may be too early to call a bottom in oil here, but if there is any hint of a demand stabilisation, the oil market has an excellent setup with inventories falling, supply tight, and Saudi Arabia committed to higher prices.

Fig 3: Brent prompt price, $/b Fig 4: WTI prompt vs M1 - M2 spread
Source: Bloomberg, Energy Aspects Source: Bloomberg, Energy Aspects

WTI: A surprise crude stockbuild in the US weekly data compounded negative macro sentiment from early in the week and helped crude prices fall steeply. But of course, the prompt WTI spread moved higher at the same time as flat price sold off, with the prompt WTI crude spread going into backwardation. Over the last eight weeks, US crude stocks have still fallen by 46.5 mb versus the five-year average draw of 21 mb. Cushing crude oil stocks drew by 4.78 mb over July to 47.4 mb, their lowest since early May. Nearby WTI spreads (both structure and inter-crude spreads) have performed well recently, although we believe the upside to prompt WTI spreads is limited due to higher flows from Canada, with Cushing fundamentals due to truly tighten at year-end and into 2020. The strength in WTI-Cushing came as WTI-Midland differentials moved inside the Basin pipeline tariff this week (which, if sustained, will reduce flows into Cushing), despite significant Permian refinery works, hydrotests on West Texas Gulf and Mid-Valley pipelines, and lingering uncertainty around new Permian pipeline start dates. Work on the Basin pipeline should reduce Cushing volumes even more. We still maintain that WTI spreads into Q1 20 will strengthen (see Data Review: US Department of Energy, 7 August 2019).

Yasser Elguindi, Market Strategist
+1 646 760 8100 (direct)

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