Cumberland Advisors Market Commentary – Draghi Signals “You Go First” to the Fed While Johnson Threatens

Author: William Witherell, Ph.D., Post Date: July 29, 2019

The European Central Bank (ECB) did not reduce key interest rates at its July meeting ending last week, contrary to the expectations of some observers. This decision leaves the US central bank, the Federal Reserve, to take the lead with a widely forecast rate cut at its meeting this week.

Cumberland Advisors Market Commentary by Bill Witherell, Ph.D.

However, ECB president Mario Draghi did strongly suggest that new monetary stimulus is likely to be adopted at the September meeting of the ECB’s governing council. This stimulus will probably include both rate cuts and new quantitative easing measures. Notably, the governing council stated that it expected rates to remain at their present or lower levels at least through the next twelve months. Draghi indicated that the European economy does not appear to be headed for a recession, although the outlook for the trade-dependent manufacturing sector has become “worse and worse.” He emphasized his concerns about inflation expectations, which now are close to an all-time low. The ECB does not want to see inflation expectations become entrenched at current levels.

The expected monetary stimulus looks timely in view of the latest data on the state of the European economy. The Flash Eurozone PMI for July indicates a relapse in the economy over the course of the month, giving up the gains of May and June. A downturn in manufacturing is the culprit, with production experiencing the steepest fall since April 2013. European trade is being hit hard by the US-China trade dispute as exports to China have suffered. Brexit concerns, serious weakness in the auto sector, and slowing world trade are also factors. A resilient service sector and healthy private consumption facilitated by lower unemployment and higher wages continue to support the subdued forward momentum of the economy.

An important uncertainty affecting prospects for the European economy, cited by Draghi, is the outcome of the United Kingdom’s efforts to withdraw from membership in the European Union. Last week the new British prime minister chosen by the Conservative Party, Boris Johnson, made clear in his opening statements that the party has become a Brexit party, with no room for those who wish to remain in the EU. He also made clear that he intends to confront the EU and showed no willingness to compromise. He has stated to the EU officials that unless the EU is willing to compromise – in particular, to abolish the “backstop” which is the part of the deal agreed by the previous British government that is designed to prevent a hard border with Ireland – the UK will be leaving the EU on October 31 without a deal. The EU immediately responded that it will not reopen the withdrawal agreement, emphasizing that abolishing the backstop would be “impossible.”

By downplaying the likely harm to the UK economy that would follow, Johnson is seeking to demonstrate that he is very willing to see the United Kingdom go through a no-deal Brexit. He has filled his government with Brexit true believers and is starting a campaign directed at advising companies how to adjust to a no-deal Brexit. He has made clear that under a no-deal Brexit he will keep the 39 billion pounds that the previous government had agreed to pay the EU. Of course, all this may prove to be negotiation bluster by the populist leader, who is viewed by many as a British Trump; and a deal may eventually be struck. But Johnson does seem to be painting himself and Britain into a corner. He still faces the problem that Parliament is strongly against a no-deal Brexit, and the government has a very thin majority. While a no-deal exit is looking increasingly likely, an early election, possibly before October 31, is also possible. The Liberal Democrats clearly support remaining in the EU, and the Labour party appears to be moving in that direction.

Despite Johnson’s assurances to the contrary, a no-deal exit would be, in the words of the IMF, one of the greatest threats to the world economy, along with further US-China tariffs and US car tariffs. These threats, should any of them occur, would “… sap confidence, weaken investment, dislocate local supply chains and severely slow global growth.” There would also be a risk of “financial vulnerabilities.”

The UK economy is not in good shape to deal with the likely shock. In June, the UK manufacturing PMI was at a 76-month low. Business optimism fell to its third-lowest level in the series history, weighted heavily by Brexit-related uncertainty and disruption. Capital spending plans are on hold because of Brexit uncertainty. The critical financial services sector is already losing jobs. Even if business is helped by increased government stimulus to offset somewhat the impact of a no-deal Brexit, the UK would likely suffer long-term damage to its reputation and security. And it would still have to negotiate a trade agreement with its largest trading partner, the EU.

Sources: The Financial Times, the Wall Street Journal, HIS Markit, CNBC

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
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