By Benjamin Picton, Senior Macro Strategist at Rabobank
And Now For Something Completely Different
The debt ceiling fracas is mercifully behind us (at least until 2025), so today we turn our focus away from the USA’s dwindling treasury and towards the more immediate issue of its dwindling dominance of the Western Pacific. Over the weekend US Secretary of Defense Lloyd Austin urged China to re-engage with the United States to “help avoid misunderstandings or miscalculations that may lead to crisis or conflict.” The plea was timely, because there have been a few near-misses in recent days that might have caused more concern in markets in years gone by. The first was the interception of a US surveillance plane by a Chinese fighter jet over the South China Sea in late May. The Chinese jet crossed in front of the US plane, thereby forcing it to fly through the unstable jet wash (just like Maverick and Goose). A further incident occurred on Saturday when a Chinese warship cut directly in front of a US destroyer, passing within 140 meters of colliding with the US ship.
If you’re sensing a theme here, you’re not alone. Western leaders have been promising a “de-risking”, rather than a “de-coupling” of the China relationship in recent months, but the geopolitical risks seem to be increasing, rather than diminishing. When Christine Lagarde warned in April that “we are witnessing the fragmentation of the global economy into competing blocs” she was effectively articulating our long-held house view, which my colleague Michael Every has written about many times.
So, when Western leaders talk about “de-risking”, what they mean is that they want to ensure that unfriendly powers don’t have them over an economic barrel in the same way that Vladimir Putin did with Europe in early 2022. The goal is to restructure trade and production so that it cannot be used as a weapon in this new era of Great Power competition. This is easier said than done. Especially when we are accustomed to a world where one bloc does most of the producing and another does most of the consuming.
If the world really does split into competing blocs in the way that Lagarde has warned, we are going to have to see further economic restructuring to make it work. In the meantime, there will be a process of muddling-through, as we continue to sell and buy what we can, while doing our best to re-shore, on-shore and friend-shore, since we are un-sure about the reliability of supply for certain goods and commodities in the years ahead.
Such a restructuring probably means inflation in the West (that is certainly our view) and deflation in the East. If the West is going to be making more of its own stuff, it is off to a slow start. The ISM manufacturing index last week showed further contraction, continuing a trend that started in November last year. New orders were down, inventories were down, prices paid were WELL down, but the employment index grew strongly. That’s an interesting result given the continued strength in non-farm payrolls, which again surprised to the upside on Friday by reporting that employment rose by 339,000 in May against a forecast of just 195,000. This coincided with a 3-tick increase in the unemployment rate to 3.7%, which meant that there was something for everyone in the numbers. Consequently, the stock market rallied, as did the Dollar, as did 10-year Treasury yields (up 10 bps on the day), and the front end underperformed as the market awaits new issuance and a clearer signal on the path of the Fed Funds Rate.
Despite a poor recent run for both the USA and Germany, it would be unfair of me to characterize the malaise in manufacturing as a purely Western phenomenon. China has had its troubles this year, too. Last week’s PMI data presented a mixed picture on this front, with the Federation of Logistics and Purchasing numbers showing a further contraction in May, while the Caixin manufacturing PMI showed an unexpected lift back into expansion. By contrast, the Caixin services index continues to show remarkable strength. The May data was released earlier today and showed a rise in the index to 57.1, which seems to imply that there is still some steam left in the China re-opening trade. There has been speculation for some weeks now that the Chinese government would soon step in to provide broad stimulus to the economy, but these latest Caixin numbers may cool those expectations for the time being.
Signs of a pickup in China is always welcome in Australia, where the wealth of the nation is largely generated by digging things up to sell to Chinese steel mills before being redeployed into the local housing market. The sustainability of how that national wealth is shared was called into question on Friday when the Fair Work Commission delivered a 5.75% increase in award wages and an 8.6% bump in the national minimum wage. Industry awards cover somewhere between a fifth and a quarter of the Aussie labor market, so the FWC decision has a large bearing on aggregate wage outcomes. This is important, because RBA Governor Lowe had earlier in the week warned politicians that unit labor costs are rising too fast and that expected levels of wages growth were not consistent with meeting the inflation mandate unless sagging productivity growth picked up. Naturally, the implied path of the RBA cash rate is higher post-decision as traders intuited this to mean more inflation pressures and therefore a higher path for the policy rate, just for something completely different!