The US and Canada finally agreed on a new trade agreement, oil prices hit a 4-year high, and China is on pause this week.

NAFTA 2.0 Saved

On 27 August 2018, we wrote the following:

The Trump Administration is on schedule. The window of opportunity to hammer out a deal is closing, and despite political posturing, game theory suggests that Trump will agree to a new NAFTA deal before the end of 2018.

The following week, The US and Mexico announced an agreement. As of this morning, the US and Canada have just announced an agreement on trade, just in time for the Mexican President Enrique Pena Nieto to sign before he leaves office. It will now be known as USMCA, which stands for US Mexico Canada Agreement. No doubt it was too late in the night to come up with a more creative name for NAFTA 2.0.

We expect risk assets to rally higher this morning, despite a few outstanding issues for some industries. One highlight includes incentives for more automobile production in the US. This is complicated by the fact that an agreement on steel and aluminum is yet to be reached. Despite the negativity that has been surrounding the auto industry during the negotiations, we see opportunities in this sector. Markets have disproportionately penalized automakers since NAFTA was opened for renegotiation in June.

Is the bottom confirmed for China?

The CSI 300 is up again last week for an overall 2-week run of 7.3%. This happened after levies of 10% were implemented on $200 billion of Chinese imports into the US. The market is confirming our view that the tariffs will not stop China from dominating global trade in manufactured goods. Tariffs simply do not work because of their impact on FX, and it only takes a small adjustment in the USD/CNY for the tariffs to be entirely offset.

With the USD/CNY trading at the PBOC’s key level, the markets may be caught by surprise. There is a higher probability of a breach of this 6.9 level in the next week due to expected FX illiquidity during the week-long National Day holidays. The PBOC is not on duty until the 8th of October, and it would not surprise us to see traders push against that resistance.

The news this morning certainly brings hope to US trading partners. With Canada out of the way, the Trump administration will have more time to allocate to hammer out a trade agreement with China.

News from the Oil Patch

Sanctions on Iran are quickly approaching, and refineries are scrambling to find alternative suppliers. Saudi Arabia, the swing producer of last resort, has assured markets that it has the will and ability to fill any supply gap. These statements did not help last week when Brent crude closed above $83.

Structurally, the oil markets are undergoing a significant change. The shale producers have a new lease on life, and they are taking advantage of higher prices to cut costs by reducing debt. Low interest rates created an environment where cheap money allowed this industry to prosper. As interest rates rise further, we will likely see an increase in forward selling of oil by shale producers as an alternative tool for raising money to increase production.

For residents of the oil-rich Gulf, oil at $83 somehow does not feel the same this time around. GCC residents felt much richer the last time that happened 4 years ago. Saudi Arabia’s government is targeting GDP growth of 2.1%, and that is after it announced an increase in public spending of 100 billion riyals ($26.7 billion) to reach an annual spending of 1.1 trillion riyals. From an economist’s point of view, this lower growth rate is not a surprise and can be explained by the following:

  • Government revenues are rising at the same rate as the expected increase in spending. Tax revenues are at an all-time high and projected to increase to 978 billion riyals in 2019 from 882 billion riyals in 2018.
  • GDP measures a flow of income to the economy in the same way that oil revenues are a flow. GDP is starting from a higher base than where it started 4 years ago ($684 billion vs. $629 billion), and the oil price’s rate of change has a lower weight than it used to for explaining GDP growth.
  • Interest rates are rising because the riyal is pegged to the US dollar, and credit is not growing at the same rate it was between 2013 and 2015. In fact, credit to the non-financial sector has been contracting since Q3 of 2017.

The Week Ahead

While North American markets are expected to wake up on a positive note, the Eurozone may experience more volatility until we get through Italy’s mid-October deadline to present its budget. There is also market chatter about a possible S&P or Moody’s downgrade of Italian credit next month. With a current rating of BBB, we see a “junk” rating unlikely in the near future. A downgrade may present a buying opportunity for BTPs.

China is off for a week to celebrate its National Day. Russia is releasing GDP and Turkey will report its CPI figures. Markets are looking for any sign that the Emerging Market rout is over, and Turkey’s last interest rate hike may have marked a short-term bottom. The US Trade Balance is also due for release this week, which will provide more ammunition for Trump’s attacks on US trading partners.

Safe@Harbour

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