Macro: The Policy Mix And The Quad

The pandemic has synchronized the global economic cycle. Whether one was expanding in Q419 or Q20, or contracting like Mexico and Japan, nearly every country experienced a dramatic loss of output followed by what appears to have been a sharp recovery in Q3.

The magnitude of the recovery is of interest to investors, but they are looking ahead and, as the calendar turns, the economies still appear to be moving in sync and growth rates will likely slow dramatically. The emerging consensus is for the EMU and UK to grow around 2.5%-3.5% in Q4, and for the US and Japan to expand by closer to 1.25% (quarter-over-quarter).

Of course, there is great uncertainty around the trajectory of the economies because there is great uncertainty around the virus. While hopes for an effective vaccine in the next few months are still running high, improved therapies to minimize the severity and duration of the infection may be feeding into the market's optimism and facilitating a return to risk assets, including equities and emerging markets.

News that President Trump and the First Lady have contracted the virus injected a fresh note of volatility ahead of the weekend. It is a wild card, for sure, but we suspect it will not alter the polls or the negotiations over a new fiscal effort. 

Inflation in the US, EMU, and Japan is well below where officials want it. Yet the three central banks have recently declined the opportunity to take new steps to achieve their targets in a reasonable period of time, according to their own forecasts. The Reserve Bank of Australia meets on October 6, the cash rate and three-year yield target will remain at 25 bp.

The futures market has seen yields trade below the cash rate, but few analysts think it is likely this year. The Bank of England will likely be the next major central bank to ease policy, but the MPC does not meet until November 5, the same day as the next FOMC meeting concludes.

The BOE has kept the option of negative interest rates card on the table, though it is not imminent. There is scope to cut the 10 bp bank rate and step up its Gilt buying. The market expectations for negative rates appear to have shifted to Q221 from Q1. The UK may rival New Zealand as the first current account deficit country to adopt a negative policy rate in 2021.

However, of the big three central banks, the ECB may lead. Many expect it to extend its Pandemic Emergency Purchase Program, under the cover of the updated staff forecasts in December. Excess liquidity in the euro area is pushing above three trillion euros and driving down overnight interbank lending rates below the ECB's minus 50 bp deposit rate. 

The relatively light economic calendar in the week ahead may not get in the way of a resumption of the underlying trend in risk assets. The market became less pessimistic in two areas that helped bolster risk-taking appetites last week, which also coincided with position adjustments associated with month and quarter-end.

The first is the new attempt to reach a compromise on more US fiscal support. The second is that there appears to have been substantial progress in trade talks between the UK and EU. The key EU summit is October 15-16 and it is both the deadline indicated by UK Prime Minister Johnson, and recognized by the EC as necessary to ensure the ratification process.

The ebb and flow of the news stream on these two issues may drive risk-appetites in the coming days, with a couple of caveats. Although the equity market appeared to react positively to the negotiations between the Treasury Secretary Mnuchin and Speaker of the House Pelosi, the US is already on the other side of the fiscal cliff. August personal income fell by a more than expected 2.7%, even though wages and salaries increased by 1.3%. A couple of large airlines and banks announced a new round of lay-offs as some government aid has expired.

Nevertheless, there is an underlying belief that even if an agreement cannot be struck now, a package could be approved in the session, and a larger effort next year could be made. Of course, the election will determine the priorities and contours, but the configuration of political and economic considerations strongly points to more fiscal support. That conviction may help make risk-appetites become more resilient after the swoon in September.

EU fiscal support and the new 750 billion euro Recovery Fund, heralded in some quarters as the Hamiltonian Moment, may also be delayed. The immediate obstacle is the desire of the EU to tighten its enforcement of "rule-of-law," and linking it to aid. Hungary and Poland, which are under review for violations, are the obvious targets. Merkel has offered a compromise: firm links, but difficult to trigger. It may not be quite enough to satisfy either side. Still, it is embedded in the EU budget and a compromise will eventually be worked out. Of that, one can be confident.

The US sanction regime against China escalated further with the moves against SMIC. China is reportedly contemplating a retaliation of its own against a large US tech company (Alphabet) on antitrust grounds (Android). Just like it makes little sense for the other major countries to be dependent on China for many drugs and rare earths, it makes little sense for China to be beholden to the US duopoly on mobile operating systems.

While there was not the commercial dimension in the Cold War with the Soviet Union, the "Cold War 2.0" does have a military dimension, and next week it will take another step into being institutionalized. If NATO was the defensive containment of the Soviet Union in Europe, the Quad may the vehicle now. The foreign ministers from the US, Japan, Australia, and India will meet next week (October 6) in Tokyo. The first meeting of the revived group took place a year ago.

The main issue is the need to coordinate the responses to the emerging challenges, including regional issues and the shared goal of a free open Indo-Pacific. While Quad has no explicit military mandate or even institutional presence, it appears that is the direction it is moving. Some joint Indian-Australian naval exercises are a new development. Separately, recall that Japan, India, and Australia agreed last month to work together toward "supply-chain resilience" in the Indo-Pacific region. The clear implication is to counter China's dominance. 

As the US (and others) have stepped up their contacts with Taiwan, Beijing stepped up its harassment of Taipei. It has repeatedly flown several types of military aircraft through the mid-point of the straits, which it seemed no longer recognize even in the declaratory policy. China has also conducted military exercises over Taiwan's eastern waters, according to reports.

The media often notes that Beijing recognizes Taiwan as an errant province. This is fine as far it is goes, but what is unsaid is important, too. In 1978, when the US cleared strategic ambiguity and embraced a one-China policy, it was not done under the pressure that Beijing has exerted on some countries. Nor was it done under the illusion that China would become like the US. It was done under calculations under the rubric of the Cold War.

Beijing is signaling that it is serious when it says that Taiwan is a red line. Xi has demonstrated his resolve on such issues repeatedly. In Afghanistan, the US supported the opposition to the Soviet-backed government, much to its later chagrin. It saddled Moscow with a costly war to keep control; something which it ultimately failed to achieve.

The stepped-up US-Taiwan engagement, the possibility of a trade pact (endorsed by at least 50 Senators, according to reports), and even some talk about a mutual defense agreement is putting more pressure on Beijing. The decibel of its protest should be on the radar screen of businesses, investors, and policymakers.