Monday Digest

Posted 23 November 2020

Overview: more tunnel to go through before we get out into the light
The November rally in stock markets finally petered out last week, despite further positive vaccine news that bolstered optimism for next year. Now that the Pfizer & BioNTech messenger vaccine has been joined by another two-shot vaccine from US firm Moderna, and with one-shot vaccine from Oxford/AstraZeneca expected to begin distribution just after Christmas, it seems that by March, a million people a week could be receiving immunisation in the UK.

Nevertheless, resurging public health pressures across wider Europe and the US have now worsened enough to dampen the capital market euphoria of late, as it is becoming clear that despite the multiple vaccine good news stories, for the economy, households and government borrowing, the 2020 narrative of ‘worse now, better later’ is bound to be with us until at least the end of the year.

Another near-term market headwind is that despite the demise of the Trump campaign’s lawsuit in Michigan, and the recount in Georgia having increased Biden’s total votes, markets’ political concerns in the US have not gone away. The fear is that the Biden presidency could see a reprise of the hawkish and obstructionist agenda enacted by the Republican-led Senate, similar to that experienced under the Obama administration. On Thursday, US Treasury Secretary Stephen Mnuchin pressed US Federal Reserve Chairman Jerome Powell to cease programmes lending to small businesses. Meanwhile, the Senate and President have blocked the passage of more fiscal stimulus, and on Wednesday, Senate Majority Leader Mitch McConnell sent everyone home for Thanksgiving, setting up a frantic December of negotiations when the Senate reconvenes.

Nevertheless, investors remain quite bullish in taking risk. According to the longstanding and authoritative survey from Bank of America Securities, global economic growth and profit expectations are running at a 20-year high. For the more speculative end of the investment community, the suggestion is to ‘sell the vaccine’ in the coming weeks and months. That probably means there is a growing chance of volatility as we head into December. Markets are liquid at the moment, but in the absence of a continuous flow of good news, it is possible that institutional investors could lock in rather unexpected 2020 profits and shut up shop earlier than usual this year. This could prove more likely to be a year-end consolidation than a (more concerning) correction – given the persistent expectation of much better times in 2021.

And lastly, to Brexit. A deal is rumoured to have entered the room through the back door, just as Dominic Cummings carries his box files out of the front. The absence of negative press briefings from either side, and the positivity of currency markets, provide some evidence that it may be more than rumours. However, we do not expect that the timelines painted by politicians as “absolutely final” to be actually that – pan European negotiations never finish when they should – but conclude with some form of compromise, they almost always do.

Why the new Asian trading bloc deserves global respect
Bigger is definitely better when it comes to multinational trading blocs. And the newly-formed Regional Comprehensive Economic Partnership (RCEP) is officially the world’s largest trading bloc, containing a third of the world’s population and accounting for around 30% of global GDP. RCEP brings together ten ASEAN members with China, Japan, South Korea, Australia and New Zealand. These nations have now committed to lower tariffs progressively, counter protectionism, boost investment across borders and allow freer movement of goods within the region.

According to the Washington-based Brookings Institute, the RCEP is expected to add around $209 billion per year to world incomes by 2030, and around $500 billion of turnover to world trade. Southeast Asia in particular stands to gain much. The region on its own should benefit by about $19 billion annually over the same period. Beyond those direct benefits, it gives a region with significant growth potential and a massive internal market (ASEAN has a population of 660 million) access to some of the largest domestic economies in the world. It’s also worth noting that the RCEP’s provisions on tariffs will be phased in over the next 20 years, so trade benefits will build-up over time.

Over the long-term, the importance of the deal will likely be in what it signals, rather than what it has already delivered. While the RCEP does much to stimulate intra-Asian supply chains, however, details on improving intellectual property protection, labour laws, the environment and state intervention are lacking. What it does do, though, is commit East Asia’s three largest economies – China, Japan and South Korea – to mutual integration for the first time in modern history. With the creation of the RCEP, it now looks like East Asia is entering into a new phase of political and economic progress. The new Biden administration

Looking elsewhere, one of the most interesting points of the RCEP is what it will mean for India. Although one of original brokers in RCEP negotiations, the Modi government pulled out two years ago, partly because of US pressure and partly because of its own conflicts with China. Politically, cooperation with China is a bitter pill to swallow in India. But if India remains outside of the RCEP, it risks falling behind its rapidly-growing neighbours. The rules allow India to join the RCEP at any time after it comes into effect and, if US politics allow it, we suspect the government to sign up at some point down the line. Even if it does not, the RCEP has huge potential as a trading bloc. The combination of the China-Japan-Korea triumvirate together the rapidly-developing ASEAN has all the ingredients to be an economic powerhouse in the future. It may take years to see the effects, but make no mistake: RCEP could be a milestone in an eastward global economic transition.

Will populist nations derail the EU’s recovery efforts?
The European Union’s handling of the COVID crisis was one of few positives of 2020. Negotiators struck a hard-fought deal with the European Parliament to create the continent-wide €1.8 trillion recovery fund which, together with the union’s seven-year budget, was designed not just to plug the gap between now and normality, but to invest in a brighter, more sustainable and digital future afterwards. But at the final hurdle, the deal is in jeopardy again. Hungary and Poland – both led by authoritarian far-right leaders – have indicated that they will veto the spending package unless the critical ‘rule of law’ mechanism – which allows the EU to suspend funding to member states that it believes are undermining its democratic values – is removed.

This is far from the first time these two countries have faced-off against Brussels on this issue. The difference now is that the stakes are higher than they have ever been. The irony of the Hungarian-Polish blockade is that both are extremely dependent on EU funding. In 2018, EU spending amounted in Hungary and Poland to 5% and 3.4% of GDP respectively, and they are set to receive an estimated €180 billion in stimulus grants under current plans. Were Hungarian prime minister Viktor Orban and Polish premier Mateusz Morawiecki to block the EU package, they would stand much to lose. This goes someway to explaining the muted reaction to the spat from markets. European bonds and currency are both trading around their recent highs, with commentators pointing to mutual interest as a reason to be hopeful of a compromise.

It seems likely that, as very last resort, Germany would agree to excluding the dissenters if it meant saving the deal. In that case, Hungary and Poland would have no cards left to play – they would either have to take the deal or sacrifice billions in much-needed funding. Some form of compromise would allow everyone to save face. In terms of its effect on the real economy, that the recovery funds are not set to come in until next year should lessen the short-term impact of any delay. A solution is still on the horizon – and with it signs of hope for Europe’s fiscal future. But there’s no doubt that two of Europe’s leading authoritarians attempting to hold the EU to ransom is bad news for the union. Even if the threat to short-term support does not deter investors, the threat to long-term stability might.

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