Goodbye NAFTA, hello USMCA!

By David Morrison  |  01/10/2018 14:30

US stock indices soar as Canada joins the US and Mexico in a fresh trade agreement that replaces NAFTA

US stock indices stormed higher in early trade on the first day of the fourth quarter. Traders rushed in to add long side exposure after Canada joined the US and Mexico in a fresh trade deal that replaces the North American Free Trade Agreement (NAFTA). The new arrangement has been named the United States-Mexico-Canada Agreement (USMCA) and the plan is to have it signed off in November. Over the weekend, the US and Canada came to terms over Canadian access to US dairy farmers as well as Canadian exports of automobiles. USMCA also adds provisions on unfair practices, financial services, digital trade and intellectual property which will modify arrangements under NAFTA.

Italian budget worries

But while US stock index futures rallied on the news, European markets were initially mixed. Traders continue to worry about Italy's budget proposal, announced last Thursday. The new coalition government has proposed a 2019 budget with a much wider deficit than the previous administration’s target. Northern League and 5-Star offered a budget with a deficit of 2.4% of GDP for the next three years. This is likely to set up a clash with the European Commission. The Commission has demanded that Italy progressively cut the fiscal gap to trim its debt. The budget announcement was made by the two deputy prime ministers in a joint statement. This raised speculation that Finance Minister Giovanni Tria (who had sought a deficit set as low as 1.6% next year) would resign. However, he later denied this although he went on to say he would stay on to avoid ‘chaos’.

Showdown with European Commission?

The full budget will be unveiled in October and will be scrutinized by the European Commission (EC) on 15th October which could reject it according to Italy’s La Repubblica newspaper. Last week European Commission Vice President Valdis Dombrovskis said that Italy’s budget was out of line with the Euro zone’s stability and growth pact. However, it’s worth noting that the European Union has previously made concessions to both Spain and Portugal. But a rejection by the EC would inflame the Euro sceptics within the Italian government and would undoubtedly lead to further market volatility.

Budget causes panic

Italian bond yields soared on the budget news as investors dumped bonds. Italian equities, led by the banking sector, plunged on Friday although they finished off their lows. They were weaker again first thing on Monday although there was a modest rebound as the session progressed. The EURUSD fell sharply on the news, breaking back below 1.1600, although it steadied on Monday morning.

Chinese data

Sunday saw the release of some key Chinese data. The Manufacturing PMI for September slipped to 50.8, down from 51.3 previously and below the 51.2 expected. This means that the manufacturing sector is barely registering expansion and risks contracting for the first time since August 2016. However, Non-Manufacturing PMI rose to 54.9 from 54.2 and was comfortably above the 54.1 consensus forecast. The services sector continues to expand at a respectable clip and has been remarkably steady since it last contracted in March 2012.

‘Golden Week’ holiday
 
The news helped to Chinese yuan strengthen overnight. But the Shanghai Composite will be closed all this week for China’s Golden Week which celebrates the Communist takeover 69 years ago. The long holiday has the potential to be disruptive, especially as borrowing costs have risen sharply in Hong Kong over the last couple of weeks, unnerving investors there.

Fed Chairman to speak

Looking ahead, Federal Reserve Chairman Jerome Powell will speak this week, although it would be surprising if he were to say anything which could move markets significantly. Bear in mind, the Fed announced another 25-basis point rate hike last week citing US economic strength, low unemployment and solid growth. However, as James Rickards pointed out this weekend, the current US recovery has been the weakest on record. Annual GDP growth has averaged just 2.14% in the current expansion compared with an average for all expansions since 1980 of 3.12%. This difference between the two numbers represents a ‘loss’ of GDP growth valued at $4 trillion. On top of this the current recovery is, at 109 months, the longest since the end of the Second World War. The average length of recoveries since 1980 is 83 months. This would suggest that the US is overdue a recession.

RBA rate decision

This Tuesday we have a Rate Decision from the Reserve Bank of Australia (RBA). The central bank is expected to keep its headline Cash Rate unchanged at 1.50% where it’s been for over 2 years.

US Non-Farms in focus

But big data point will be US Non-Farm Payrolls on Friday. We saw a better-than-expected jobs number last month when it came in at +201,000 versus the 191,000 forecast. But a downward revision to the prior month effectively cancelled out the gain. The current consensus forecast is for an increase of 185,000 in September while the Unemployment Rate is expected to slip to 3.8% from 3.9%. But once again the focus will be on Average Hourly Earnings which came in much stronger than expected in August at +0.4 month-on-month versus +0.2% previously, or +2.9% year-on-year – the largest increase since June 2009. Further evidence of a pick-up in wage growth will trigger fears of an increase in inflation, causing investors to worry that the Fed will go ahead with its slow but relentless hiking of interest rates. If so, expect the dollar to continue to rise, putting further pressure on emerging markets and the euro.
 
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