Webcast:

• Our monthly economic webcast was published last week: “Green shoots versus tariffs”.

U.S.-Mexico tariffs:

• The U.S. threat of new tariffs on Mexico vanished just before they were set to be applied on June 10.
• We are not entirely surprised by the last-minute resolution. Unlike the rather trickier negotiations underway between the U.S. and China over the very structure of the Chinese economy, U.S.-Mexico frictions were considerably more superficial.
• The U.S. had demanded tighter border controls from Mexico – a central component of President Trump’s 2016 campaign platform. Mexico ultimately complied, committing more National Guard troops to the border and promising to process rejected migrants returned by the U.S. more quickly.
• To some extent, these Mexican concessions simply represent a return to vigilance after an easing of border security under new Mexican President Obrador.
• So long as the flow of illegal immigrants from Mexico and Central America (via Mexico) slows into the U.S, that should be the end of the story.
• However, we flag the chance that the threat of Mexican tariffs could return, for any of several reasons:
  • The U.S. has not been shy to again threaten a country with trade sanctions after striking an earlier deal. Case in point, Mexico signed onto the USMCA but was then hit with this very tariff threat eight months later. Additional threats are possible, whether on further immigration-related concerns, when the auto sector enters the crosshairs this fall, as a bargaining ploy to extract further USMCA concessions to win Democrat support, or for more foundational reasons relating to superior Mexican competitiveness and the country’s trade surplus with the U.S.
  • The definition of success in the new agreement is not clear. To our knowledge, there is neither a specific number of troops that Mexico must install on the border, nor a particular reduction in illegal immigrants that it must achieve. It may thus be hard for Mexico and the U.S. to see eye-to-eye on whether any Mexican response has been successful.
  • Mexican measures are unlikely to completely halt illegal immigration into the U.S. The U.S. could use this as an excuse to extract a major immigration concession: having Mexico sign a safe third-country agreement with the U.S., with the implication that Central American refugees would be compelled to claim asylum in Mexico rather than continue on to the U.S.
• President Trump has also reported that Mexico will buy more American agricultural products, but this does not appear to be a formal part of the deal.
• For context, the number of illegal immigrants entering the U.S. reached a 46-year low in 2017, arguably for two reasons. The first is that inward illegal border crossings have been down ever since the financial crisis as the U.S. became a less attractive destination from an economic perspective. Second, President Trump’s tighter border security has discouraged many from even trying to traverse the border.
• However, illegal immigration rebounded in 2018, helping to bring the subject to greater political prominence.
• The number of deportations has been growing for some time. This actually began under President Obama, wherein illegal immigrants with criminal records were deported in sizeable numbers. This has further increased under President Trump after a zero tolerance policy was implemented in 2018.
• From an economic standpoint, the decision not to levy tariffs on Mexico is clearly positive and has been interpreted by financial markets as such. But be warned that the threat could yet return.

Rare earths:

• The U.S.-China trade battlefield has expanded from merely tariffs to encompass non-tariff barriers such as corporate-level sanctions and limiting certain specialized exports. China’s domination of the rare earths industry has attracted considerable attention as a possible pinch-point that the country could leverage. To this end, China has now threatened to withhold its vast supply of the materials.
• China currently produces 70% of the global supply of 17 exotic elements that are used in the creation of many magnets, alloys and electronics. Disk drives, microphones, speakers and screens are all produced with rare earths. Gasoline refining also traditionally uses a rare earth catalyst.
• Consequently, any curtailment of Chinese rare earths could create a pinch-point in the U.S. and global hardware sectors, hurting the economy. The U.S. is even more reliant on China’s supply than the global average (80% originates in China).
• However, we do not see the threat of a Chinese rare earths embargo as overly dangerous:
  • First, the industry is fairly small. The U.S. only imports $160 million worth per year, a pittance in the context of a $20 trillion economy. This means that if supply shortages were to increase prices significantly, the economic hit would be minimal.
  • Second, China only leads the world in rare earths production because of its lax pollution controls and thus lower costs. In actual fact, the elements are plentiful around the world. One – cerium – is more common than copper. Granted, rare earths are more dispersed than for base metals, such that it can be hard to find the substance in sufficient concentration to be economic. But the point is that every country has some – this is not a Saudi Arabian oil situation.
  • Third, China’s last attempt to pinch the market in 2010 backfired badly. Going into the episode it had nearly 100% of the global supply. Afterwards, encouraged by higher prices and chastened by the unreliability of China’s production, other countries re-opened previously mothballed mines. China’s production share fell to the aforementioned 70%. As a result, China may be reluctant to actually cut off the world again.
  • Fourth, other countries are already being incented to increase their production. Companies that produce rare earths have seen their stock valuations rise by nearly 50% since trade relations deteriorated in early May. Australia has a significant mine and projects are underway in the U.S. and Canada.
  • Fifth, companies can, to an extent, find a way around a rare earth blockade. In 2010, gasoline refiners were able to continue refining without the specialized elements. Screen-makers were able to substitute other materials for the unavailable elements.
• In summary, any Chinese decision to halt export of rare earths might be consequential, but not an economy-killer.

Economic weakness vs. strength:

• Recent U.S. economic weakness has been much discussed: a payrolls print that created half as many jobs as expected (75K) and none at all once downward revisions to prior months were accounted for. Similarly, the bellwether ISM Manufacturing index fell yet again, this time from 52.8 to 52.1.
• While these outcomes are undeniable and negative, they are not quite as bad as they first seem.
• For the May payrolls report:
  • the unemployment rate remained rock-bottom at just 3.6%
  • total hours worked increased at a tolerable pace
  • other employment gauges like jobless claims and the employment inputs within the twin Institute for Supply Management (ISM) indices actually rose in their latest incarnations.
• As a result, it is far from certain that U.S. job creation has permanently tumbled below the triple-digit mark.
• Similarly, the ISM Manufacturing Index, while slightly lower, contained nice gains. New orders rose from 51.7 to 52.7 while employment inputs increased from 52.4 to 53.7. Many view those two subcomponents as no less important than the headline series itself.
• Finally, there are a variety of economic indicators that point to economic stabilization or even acceleration – notable claims after nearly a year and a half of weakening activity:
  • The ISM Non-Manufacturing in May rose to a strong 56.9 (from 55.5), with production, new orders and employment all accelerating.
  • U.S. consumer confidence remains very high, consistent with ongoing consumer spending growth.
  • The qualitative Beige Book published by the Federal Reserve has continued to improve, noting a slight acceleration of business activity in each of the past two releases.
  • A handful of composite economic data change indices for the U.S. have stabilized or rebounded since April.
• The point of this list is not to claim that all is well, but instead to highlight that economic data remains profoundly mixed rather than purely negative.
• It is interesting to note that to the extent weakness is visible, it appears disproportionately in the manufacturing sector (providing further validation, durable goods orders are also down on the year). On the other hand, more service- and consumer-oriented sectors are holding together fairly well. Tariffs may provide some of the explanation for the difference.
• It makes sense that economic growth may be stabilizing after a long swoon thanks to a substantial decline in interest rates, discussed in the next section.

Lower rates:

• Bond yields are down sharply.
• Of greatest prominence, the U.S. 10-year yield has plummeted from 3.25% in early November to 2.59% in mid-April to just 2.13% in early June. In so doing, the yield has fallen by a third.
• Canadian bond yields are down similarly, from 2.60% last October to just 1.51% now.
• Outside of North America, U.K. yields have halved since late 2018 while German yields have reached new all-time lows with an outright negative yield of just -0.22%. This is down from +0.57% in mid-October, and lower than any point during the global financial crisis, the sovereign debt crisis or the 2015—16 flare-up.
• The rationale for this synchronized decline in yields relates to several interwoven developments:
  • economic growth is slower than it was last fall
  • there have been substantial bouts of risk aversion along the way
  • central banks have become considerably more dovish.
• Markets have now priced in an 18% chance of a rate cut at the U.S. Federal Reserve’s next decision on June 19, and a sizeable 83% chance of a cut by the central bank’s July meeting. Recent comments by Fed Chair Powell have to some extent fanned the flames, acknowledging the importance of monitoring trade developments and promising to act as appropriate to sustain growth. All of this is a substantial reversal for a central bank that was once expected to deliver several rate increases this year.
• Market expectations have not shifted as radically for the Bank of Canada, particularly after the central bank acknowledged the strength of Canada’s labour market, but the market now prices in a 35% chance of a rate cut by October for Canada.
• The latest ECB decision delivered two new forms of stimulus:
  • enhanced liquidity provisions
  • an extension of the central bank’s forward guidance not to raise rates before the middle of 2020.
• However, the market felt some disappointment in that commitment, as it had hoped the ECB would also introduce language about the possibility of interest rates going down over the relevant period.
• Interest rates have fallen an awfully long way. We flag the risk that yields have fallen a little too far, and relatedly that the market may be expecting too much rate cutting from central banks:
  • First, economic conditions are far from awful, as detailed in the prior section. And the very fact that interest rates have fallen so far should help to stabilize growth over the remainder of 2019.
  • Second, in the U.S. context, it isn’t clear to us that a rate cut should be viewed as baked into the cake by July. Don’t get us wrong: rate cuts are more likely than rate hikes. And a near-term reduction is undeniably possible should the business cycle begin to droop or protectionism become significantly worse. But, absent that, inflation is in the vicinity of the central bank’s target, the unemployment rate is extremely low and growth is hanging on. An unchanged policy rate in the near term seems more likely.
  • Third, there is a big divide between the bond market and the stock market. Stocks are currently near their highs at the same time that bond yields are near lows. This is unusual. The truth may lie somewhere in the middle.