Spying, Trying And Frying

By Elwin de Groot, Head of Macro Strategy and Philip Marey, Senior US Strategist at Rabobank

Apart from the “Eurozone-recession-after-all” news, it is geopolitics that are in the limelight again. First of all, more and more commentators are now saying the Ukrainian counter-offensive has begun in earnest, as Western-supplied tanks have been spotted on the battlefield.

Secondly, as the Wall Street Journal reports, in a move reminiscent of the Cold War, Cuba and China struck a deal allowing the Chinese to set up an electronic surveillance facility on the island, which is located close to the Florida coast. Between 1962 and 2002, the Soviet Union operated a similar facility at the Lourdes base, close to Havana. In 2014, there were reports that Russia would reopen the eavesdropping facility. China has been expanding its economic activities in Latin America, focusing on trade and investment in Brazil, Argentina and Chile. This has given China increased access to commodities crucial to its economy. Cuba has been of less interest economically, but its troublesome public finances, close proximity to the US and communist history have made the country more likely to accept money for Chinese military access. After an initial improvement of relations under the Obama administration, President Trump tightened financial restrictions and sanctions against Cuba. The Biden administration has only loosened some of the restrictions, restricting Cuba’s capacity to grow. Venezuela, a nearby communist ally, facing problems of its own, has reduced its supply of cheap fuel to Cuba. While the US is bolstering its alliances in the Indo-Pacific, the Chinese have come to America’s doorstep.

Meanwhile, President Biden wrote an op-ed in the Wall Street Journal, claiming 13 million new jobs since he took office and a below 4% unemployment rate for 16 months. As his major legislative accomplishments he touted the Inflation Reduction Act’s reduction in health care costs (and suggested the IRA also brought down gasoline prices and inflation), the public investments in infrastructure, semiconductor industry and clean energy industry (the bipartisan Infrastructure Investment and Jobs Act, the CHIPS and Science Act, and again the Inflation Reduction Act), and the recent debt limit deal. So these are the accomplishments he will be selling in the next election campaign. He conveniently forgot to mention the American Rescue Plan’s contribution to inflation (which was supposed to be transitory). He also did not mention that initially he did not want to negotiate about the debt limit at all, until the House Republicans surprised him with the Limit, Save, Grow Act. Going forward, he stressed the importance of making US markets and industries more competitive and resilient and that he will push for closing tax loopholes and raising revenue from wealthy Americans and the large corporations. Good luck with that now that Republicans have taken over the House of Representatives. Still, his accomplishments show his ability to reach across the isle. This suggests that we could expect additional bipartisan legislation, which would also improve his standing among centrist voters.

Turning to Europe, yesterday’s data from Eurostat confirmed that -with hindsight- the Eurozone economy had slipped into a mild (technical) recession, as Q1 growth was revised to -0.1% q/q, marking the second consecutive quarter of decline in economic activity. That said, energy saving measures, government support, tight labor markets and more resilient investment in the face of those tight labor markets (helped also by EU-programs-led investment spending) all made that this was not more than a technical recession. Although stagnation for the remainder of the year remains our base case as monetary and credit tightening will increasingly weigh on spending, in particular private fixed investment, we actually project a slight pickup in activity in Q2 as consumption is increasingly supported by rising wages and falling energy inflation, whilst investment (notably in the South of Europe) keeps being supported by European funding.

On that note, the European Commission yesterday approved a tranche of EUR8.1 billion in state aid, covering 68 projects undertaken by 56 companies, to stimulate innovation in the European semiconductor sector. This is still small beer when you consider the huge investments that are required in this area, but at least Europe’s trying. The incentives are also expected to unlock an additional EUR13.7bn in private investments. Developments in equity markets at least suggest that there is no lack in investor appetite on this front. Technology stocks have been a key driver of recent gains. The Eurostoxx 600 technology index has advanced nearly 8% since the end of April, the S&P500 information technology index is up more than 10% over that similar timeframe.

Back to the Eurozone recession-after-all: this is unlikely to change the ECB’s minds. The debate is already evolving from pinpointing the amount of hiking that is still needed to the amount of time that the ECB needs to keep its policy rates at that peak. A 25bp hike has been well telegraphed, and the GDP data probably won’t materially change the Council’s assessment, considering that it was such a small decline and mostly driven by the energy shock that is now starting to fade, rather than the impact of the ECB’s tighter policy stance – which will only run into the GDP data in coming quarters.

With the Council’s focus shifting to the ‘pause’, their communication will probably do so too. The new staff projections may play an important role in that communication strategy. The forecasts are based on technical assumptions derived from financial markets. So the ECB can leverage its staff projections to indicate how much it (dis)agrees with market pricing. A small improvement in the inflation projections may be used as a signal that the ECB does not dislike the market’s current pricing of a 3.75% terminal rate. That said, keeping the 2025 inflation forecast a smidge above 2% would support a more hawkish narrative that traders are pricing a reversal to cuts too early.

Turning to China, policy makers there have entirely different fish to fry. While the consumer price index rose slightly from 0.1% y/y in April to 0.2% y/y in May, the PPI y/y rate fell to its lowest point since the first quarter of 2016. Producer prices have been affected by lower commodity prices but also have come down due to weakening domestic and foreign demand. China’s post zero-covid recovery already seems to have run out of steam. Consumer demand is weaker than expected, the real estate sector is still struggling and weak demand from the West is also putting a lot of pressure on China’s exports. With producer prices falling even further, deflation seems to become a real risk for the economy since it would increase default risks for the already highly indebted real estate sector and some local governments. No surprise, therefore, that calls for the People’s Bank of China to cut interest rates are growing. And this is exactly what the president of Shanghai University of Finance & Economics and former advisor to both Xi-Jinping and Li Keqiang, Liu Yuanchun has advocated. Growing expectations of a rate cut/rate cuts are feeding into the market and some expect a rate cut as soon as on June 15. We predict one rate cut at the start of the third quarter and one at the start in the final quarter of this year although the upside risk is that indeed the PBOC will already decide to lower the interest rate in June. Rate cut expectations have contributed to yuan weakness vis-á-vis the dollar and the current USD/CNH Rate stands at 7.133. We see USD/CNH at 7.15 at the end of the next quarter and expect further weakness bringing the pair to 7.20 at the end of this year.