Market Insights – March 5th, 2018

Weekly financial & economic analysis.

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Essentials

Arms have been at the centre of the political stage in recent days. First, the Chinese government announced that military spending would increase by 8.1% versus 2017, and then Mr Putin spent much of his annual ad-dress to the Russian parliament praising his army’s (new) weapons capabilities.

Haruhiko Kuroda, who was re-elected as governor of the Bank of Japan, stated that the country’s 2% inflation target was “not set in stone”. This announcement contradicted previous statements, which had sought to reas-sure the financial markets. This abrupt about-turn caused the yen to rise and the stock market to slide.

Global concerns about US trade policy returned, as Mr Trump’s announced steel and aluminium tariffs sparked a sell-off in commodity currencies.

Trump steals the limelight from Powell

Investors and economists hadn’t even finished going over the speech made by the new chair of the Federal Reserve when the media’s attention shifted ab-ruptly. Last Thursday, Donald Trump announced a tariff of 25% on imported steel and 10% on imported aluminium. Stock markets slumped around the world as investors’ fears of an escalation in protectionist measures grew. A large-scale trade war would be damaging to the global economy. While such conflicts have been rare throughout history, trade tensions focused on specific products are quite frequent, especially when it comes to the USA. It’s almost certainly too early to worry that the tariffs will have any serious adverse effects.

As long as they target a few products, the impact will be limited. How the USA’s trade partners react will also play a role, and there will no doubt be counter-measures. But at the end of the day, Trump’s announcement comes as no real surprise. He promised such measures during his presidential campaign and, above all, is looking to score points with his electorate in the run-up to the mid-term elections, particularly in the coun-try’s heartland, which voted heavily in his favour. What is more surprising is that China, the most frequent target of such attacks by the US administration, will not be impacted by these tariffs, which will mainly affect the USA’s strategic trading partners. The renegotiation of the North American Free Trade Agreement with Canada and Mexico promises to be tense, since these two countries account for a quarter of US steel imports. In addition to the econom-ic impact, we’ll be keeping an eye on the knock-on effects that these tariffs will have on inflation. As long as they remain limited to steel and aluminium, their impact will be marginal. The US car industry has hinted at a cost increase of USD 40 in the price of a car worth USD 30,000, which alone won’t trigger a hike in consumer prices. Last week, we learnt that the Fed’s leading inflation indicator remained steady: the personal con-sumption expenditures deflator rose 1.7% year over year (+1.5% excluding energy and food prices). But this reas-suring news went largely unnoticed by the markets.

Italy: head in the stars

As expected, there was no parliamentary majority following Italy’s elections, and anti-establishment parties recorded major gains. Talks will now begin, and it could be a long and uncertain process. At the time of writing, the reaction to the Italy elections was more muted than expected, as this news was offset by the announcement of a new government being formed in Germany. The Italian elections sparked less uncertainty than other political events in the eurozone in recent months. The Milan stock market has been one of the top performers in Europe, and yields on Italian bonds have remained at record lows. There are sev-eral reasons for this more moderate reaction. First, these elections took place in a brighter economic climate: in 2017, Italy’s GDP rose 1.5%, its fastest pace since 2010. Second, an electoral law passed last year favours parties that can form a coalition. And finally, populist parties have toned down their talk of Italy leaving the eurozone, which reduces the systemic risk significantly.

The political risks seem under control in the short term: the 2018 budget has been approved and the economy is do-ing well. Depending on who makes up the new government, however, the struc-tural reforms that Italy needs could be put on the back burner, which would make the country extremely vulnerable during the next recession.

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