Globalization 2.0: Can US & EU really “friendshore” away from China? Plus first post mortem on gilt market meltdown

We should keep on going along the path of globalization. Globalization is good... when trade stops, war comes (and vice versa). This week, we’re sharing our prognosis on how the structure of global supply chains will change as notably the US and Europe are seeking to lower their exposure to geopolitically non-aligned suppliers. Which candidates are best positioned for closer trade relations? Where will bilateral trade cooperation intensify? Which sectors are most affected? Globalization, trade and the stance of central banks and recession indicators were also among the topics Ludovic Subran, our chief economist, discussed during recent CNBC and Bloomberg interviews (TV and radio ). Our second topics this week is the fight of the Bank of England for more financial stability faced with the recent gilt market evolution and the growing risk for corporates. Plus our weekly wrap-up on relevant economic events this week.

Globalization 2.0: Can the US and EU really “friendshore” away from China?

You can find the full report here .?

• Globalization is changing, not dying, but recent crises have raised questions about the structure of global supply chains, and the exposure to geopolitically non-aligned suppliers. The world’s openness to trade has been plateauing since 2008, without showing a clear declining trend. But this overall trend masks the increasing divergence between regions, with stronger regional integration in Asia-Pacific and Africa (weaker in Europe and the Americas), as well as the development of certain technologies and sectors. At the same time, mounting geopolitical tensions are pushing the US and Europe towards reducing their dependence on China. In fact, China already started to lose market share in US imports since 2018 and the trade war, in part to the benefit of Asian competitors. Yet, ‘friendshoring’ is easier said than done.
• We find that computers & telecom, electronics, household equipment, metals, autos & transport equipment, chemicals and machinery & equipment are the most globalized sectors – and most exhibit a strong exposure to China. Together, they account for more than 50% of global trade. The supply provided by China to the rest of the world ranges from 6% (for autos & transport equipment) to 27% (for computer & telecom, electronics, household equipment) of global output in these sectors.
• More importantly, China is a critical supplier for 276 types of goods for the US, and 141 types of goods for the EU. Conversely, the US is a critical supplier to China for just 22 types of goods, and the EU for 188 types of goods. This means that, in an extreme scenario where US-China and EU-China trade relations are completely cut off, the US and Europe have more to lose: The loss of critical supplies would cost 1.3% of GDP for the US and 0.5% of GDP for the EU, but 0.3% of GDP for China. Note that as recently as 2018, the US’ critical dependence on China was around half of what it is today (0.7% of GDP vs. 1.3%).
• Mexico, South Korea, Japan, Vietnam, Indonesia, Brazil and Malaysia could be the best positioned as ‘friendshoring candidates’ for closer trade relations with the US and the EU. But the US and the EU could also look to increase bilateral trade cooperation. With 300 types of goods concerned, the EU actually comes up as the most frequent critical supplier for the US. But in terms of size of imports, these supplies represent just 4% of total US imports – compared with nearly 10% when it comes to US critical imports from China. A free-trade agreement could be an option to close this gap, especially as the EU is becoming very dependent on the US for energy supply (oil and gas).

Gilt market meltdown – A first post mortem and key takeaways

Our comprehensive analysis can be found here .

• The gilt crash in the UK was not a repeat of the Eurozone sovereign debt crisis, but rather a liquidity-induced market accident that put financial stability at risk. As credit-default swaps (CDS) for the UK did not follow the surge in sovereign yields, liquidity risk caused the movement in gilts, rather than credit risk. It was also not a financial dominance conflict between central banks and markets as the Bank of England acted as a backstop for and not against markets. In our view, the high risk to financial stability will make more central banks likely to exert upward pressure on short-term rates while keeping long-term rates under control.
• Trading on the gilt market will continue to be bumpy for a while. But the UK is not an exception when it comes to liquidity risk. It was affected first because of the unfortunate interaction of monetary (tightening) and fiscal policy (easing) signals. Similar liquidity squeezes may develop, mainly in the Eurozone but also in the US since bond-market volatility has reached levels unseen since 2008-09 and safe collateral is still scarce.
• We believe the BoE will need to remain the ‘lender of last resort’ beyond end-October and delay its quantitative tightening program to restore confidence. A real fiscal policy U-turn is also still necessary, going beyond the cancellation of the top 45% tax rate (which will save GBP2.5bn). As it stands, the fiscal package will push the UK’s fiscal deficit to close to -7% of GDP in 2023 and public debt to 103% of GDP. Hence, all eyes will be the medium-term fiscal path, which the chancellor is expected to present as early as this month, given the crisis. As +100bp higher sovereign rates equal to fiscal efforts of 0.5% of GDP for debt stabilization, and as general elections approach, the risk of fiscal slippage remains very high in a context of potential growth around +1%. As a result, it seems difficult for the BoE to start gilt sale operations of GBP10bn per quarter on 31 October, as currently planned.?
• In light of the high twin deficits, further GBP depreciation cannot be ruled out. We expect a decline of -7% against the USD if fiscal credibility is questioned again by end-November. In such a fragile environment, the BoE would be forced to hike interest rates faster (to 4% at end-2022, 150bp above previous expectations) but with limited impact on the GBP.
• Higher financing costs could push up corporate risk. The +150bps additional increase in rates will cut corporate margins by close to -2pp and push up corporate bank loan rates by +130bps. Cash buffers remain 35% above 2019 levels but are mainly concentrated among large companies. Hence, the potential liquidity stress coupled with the rise in energy costs will increase the share of SMEs at risk of defaulting to beyond 20% in the UK, back to pre-Covid levels. Overall, we expect business insolvencies to rise to +15% above pre-Covid levels in 2023 (to 25,400 cases).

Weekly wrap-up

• High-frequency data on real activity in the Eurozone and the US suggest a progressive slowdown. Eurozone business activity has slowed down for the third month in a row. Slower manufacturing and cooling job market also point to darkening clouds over the US economy.
• In the meantime, Germany’s massive “gas shield” stuns Europe as members agree in new energy measures.
• Net capital outflows have picked up again in emerging markets, underscoring concerns about the impact of rapidly tightening financing conditions triggered by the US Fed’s rate hikes.
• Rates markets in advanced economies (US, Eurozone, UK) remain highly volatile as higher demand for liquid secure assets could put downward pressure on long-dated yields.
• Pressures in emerging markets have abated after a turbulent ending of September, with sovereign spreads decreasing and the MSCI EM index rebounding.