Lessons of History Can Help Improve Sino-US Ties

Since assuming his position as UK prime minister, Rishi Sunak has been accused of being indecisive, overly managerial and not enough of a politician. Yet, for a man who has cancelled HS2, fired a home secretary and recalled David Cameron all in a short period, he seems rather determined and active.

While most of the media were astonished by the appointment of David Cameron as foreign secretary and into the House of Lords, some were not so surprised. Cameron was always far too young a politician to be remembered solely as an ex-prime minister without a proper position to follow. There are precedents for an appointment like this: Alec Douglas-Home was appointed foreign secretary in 1960 while being an ex-prime minister. Peter Carrington in 1979 was also appointed foreign secretary as a member of the House of Lords.

However, the House of Commons does not like senior ministers being appointed in the Lords, and that predictable reaction was not long in coming. The second chamber plays a useful role in allowing people who are not members of parliament to be involved in government.

Though the announcement of Cameron’s appointment sharply divided opinion among Conservative MPs, many welcomed the return of an experienced politician with a record of winning elections. Others on the right felt the appointment of Cameron coinciding with the sacking of former home secretary Suella Braverman confirmed suspicions of a drift to the centre and a betrayal of the new red wall Tories.

So why did the prime minister appoint him? By all accounts, Sunak had been consulting Cameron privately and regularly. Cameron is a brilliant communicator; far better than any current cabinet minister. However, he has a past with a certain amount of baggage, but this is outweighed by his experience of both domestic and international politics.

Even so, it is important not to overstate the impact Cameron will make. He may be a source of wise advice on strategy and party management, but this doesn’t mean he can shift the political dial dramatically.

As foreign secretary, he will slip effortlessly into the role. Even as a former remainer, he will have no difficulty pushing for new trade agreements and emphasising our ‘new Brexit freedoms’. He will want to improve Britain’s relations as a third party with the European Union, building on what Sunak has already done with the Windsor framework and the Horizon programme.

It is also known that Cameron has been a strong supporter of Israel. That will continue. He may, however, have to moderate his views is in relation to China, where he, along with former chancellor of the exchequer George Osborne, was a strong advocate of deeper commercial ties and political engagement. At present, opinion in the Conservative party, just as in the US’ Republican party, has become increasingly hostile to China. Cameron will have to navigate carefully and accordingly.

Whatever effect Sunak intended the announcement of the new foreign secretary to have, it was immediately overshadowed by Braverman’s bitterly direct and personal attack on the prime minister. Swiftly following her departure was the announcement of the Supreme Court ruling on her brainchild Rwanda scheme – the verdict on which is a massive reverse for the government. There may be some solutions to the issues posed by the court finding but it is difficult to believe these answers can be put into effect before the general election. The ticking of the clock seems to be getting louder.

If the Conservative party is going to have any chance of avoiding a massive defeat at the next election, it needs to regain some sense of unity and purpose ahead of personal ambitions. It does not need a civil war which nobody can win.

The People's Bank of China will release its benchmark lending rates, the five-year and one-year loan prime rate. We are expecting it to follow the medium-term lending facility (MLF) rate to stay put.

Activity data released in the past few months have shown modest improvement in China's recovery, which together with concern about the weakness of the CNY, mean that rate cuts will probably be avoided for now.

Bank Indonesia (BI) is expected to hold rates steady at 6% next week. A better-than-expected trade report coupled with the rebound of IDR suggests that there is little pressure on the central bank to hike rates, so they should remain unchanged in the central bank's upcoming meeting.

Next week, Japan's October CPI inflation will be out. We expect headline inflation to reaccelerate to 3.3% YoY in October (vs 3.0% in September). Prices of fresh food and energy will be the main drivers, but prices of other services are also expected to rise, reflecting the accumulated input price upward pressure.

Core inflation (excluding fresh food and energy) will likely stay above the 4.0% level, which is likely to shift the Bank of Japan's policy stance more towards the neutral from the ultra-easing bias.

Singapore headline inflation could inch up slightly to 4.2% YoY from the previous month's reading of 4.1%. Compared to the previous month, prices might actually dip slightly by 0.2% month-on-month. Meanwhile, core inflation – the preferred measure of the Monetary Authority of Singapore – could be steady at 3%.

UK Chancellor Jeremy Hunt is likely to be gifted with a rare bit of good news as he gears up for his Autumn Statement on 22 November. Not only has borrowing come in £20bn lower than forecast so far this fiscal year, but new projections from the Office for Budget Responsibility (OBR) are likely to show that he has a little more wiggle room to play with, whilst still meeting his main fiscal goal of lowering debt as a share of GDP within five years.

It’s true that markets expect Bank Rate to be roughly one percentage point higher than when the OBR last produced forecasts in March, which is likely to push up the forecast for debt interest (net) by roughly £18bn in 2027/8 by our estimates. But that has, of course, gone hand in hand with higher inflation.

That translates into higher nominal spending on things like welfare, though the government is reportedly looking to temper that increase by uprating welfare benefits by October's (lower) inflation reading, rather than using September's (higher) reading as is more typical. But higher inflation also means more money coming in for the Treasury, and that’s what’s likely to dominate the new OBR projections.

When we wrap all of that together and plug our own inflation/wage forecasts into the OBR’s “ready reckoner” model, those extra revenues outweigh the negative impact of higher interest rates and inflation on spending.

Our rough estimates suggest the chancellor will be landed with roughly £15bn in “headroom” against his fiscal targets, which is an increase from the £6.5bn available back in March. That figure is based on market rate expectations, and we reckon that figure would rise by a further £6-7bn if we’re right that the Bank of England cuts Bank Rate more aggressively than markets expect over the next couple of years.

Whichever way you cut it though, that’s still not a huge margin to play with. Hunt’s predecessors, particularly those in post before Covid, typically built in larger headroom than the £15bn likely to be available to the Treasury next week. It means he doesn’t have much to play with ahead of an anticipated election next year, which we’re assuming comes in October 2024 (though formally it can happen at any point before the end of January 2025).

That’s even more true when you consider that some of the budgetary assumptions underpinning the forecasts described above look unrealistic. Hunt managed to win back markets this time last year with an Autumn Statement that combined some near-term stimulus with longer-term austerity, via an even mix of tighter tax and spending policies. Those included a 15% cut to public sector net investment in nominal terms annually by 2027/28 - or put another way, it goes from 2.9% of GDP to 2% over that same time frame.

One particular challenge with this is that it appears inconsistent with the government’s net zero commitments. The pathway that the government has committed to will almost certainly require heavier public investment than we’ve seen so far (particularly in buildings). The opposition Labour Party has pledged to increase investment in this area, and the Institute for Fiscal Studies reckons this would limit the fall in net investment to 2.5% of GDP by 2027/8.

The OBR’s forecasts are also based on government plans to limit day-to-day spending in government departments, such that in real terms, per capita expenditure will fall over the next couple of years. The scale of those real-terms cuts will be more aggressive in departments where budgets are not protected, and these could be challenging to achieve in practice.

Finally, the plans for later this decade also assume that some of the government’s flagship tax policies are only temporary. That includes the government’s capital allowances, which allow firms to offset certain investments against their tax bill, and are slated to end after three years. Extending that looks inevitable, and would likely cost £9-10bn/year, eating up more than half of the chancellor’s already tight “headroom”. The OBR’s forecasts also assume that a 5p/litre cut to fuel duty is phased out, and that this is uprated by inflation in future years – something that hasn’t happened since 2011 despite repeated plans to the contrary.

Does all of this rule out a sizable cut to, for example, income tax ahead of the next election? Hunt shelved plans to cut the basic rate of income tax from 20% to 19% this time last year, with a saving of £6bn/year later this decade. It’s possible that these plans will be reheated in the spring ahead of the forthcoming election, and it’s likely that the chancellor will have the fiscal space to do so. But that’s likely to be as far as the government can go without making even deeper planned cuts elsewhere later this decade.

None of this would likely move the needle for the Bank of England. A tax cut of that magnitude, if it comes, is unlikely to make a decisive difference to next year’s growth outlook. More importantly, we think by the spring it will have become more evident that inflationary pressures are cooling, and by summer we think both services inflation and wage growth will be back to the 4% area. While still too high for the BoE’s liking, we think that would be sufficient to unlock rate cuts by August.

The eurozone labour market has performed remarkably well in recent years. Job growth has been stronger than GDP growth in recent quarters and unemployment has fallen to the lowest level in decades. This has resulted in widespread labour shortages, which has boosted wage pressures.

Even though unemployment has not yet ticked up, signs of cooling are starting to show. Vacancy rates have been falling from their record highs across eurozone economies in recent quarters and surveys indicate that hiring intentions have slowed substantially in 2023. It looks like employment growth is still positive for business services, but for manufacturing, there are good indications that employment growth will turn negative before the end of the year.

Even if the services sector keeps overall employment growth positive in the short run, it is industry which usually provides the benchmark for negotiated wage agreements. If employment in industry starts to drop, this will likely have a broader impact on union demands for wages in 2024.

Historically, inflation remains one of the most important drivers of wage growth in the eurozone as negotiated wage growth uses the cost of living as a key input. The rapid decline of inflation over the course of 2023 would therefore historically have a moderating impact on wage growth moving forward. As this coincides with a cooling labour market, it means more moderation in wage growth is to be expected. Using a simple model with historical relations, we would expect wage growth to trend in the low 3% range in 2024, down from the latest reading of 4.4% annual growth. This is not the time to be relying on historical relationships though.

In fact, there are good reasons why wage growth will most likely turn out to be higher. Negotiated wages move slowly and are still adjusting somewhat for the high inflation of last year. Given the high inflation and resulting large negative real wage shock of last year, unions could try to go for yet another round of high wage demands. Also, unions might try to offset the end of one-off inflation compensation schemes with higher wage demands in 2024 and 2025. The ECB monitors the latest concluded negotiated wage agreements, which gives a decent sense of where overall wage growth will move in the first half of 2024. This seems to be hovering around 5% at the moment, somewhat above current levels. We don't expect further acceleration on the back of market developments, but it doesn't look like a decline in negotiated wage growth is imminent either.

Outside of negotiated wage growth, wage growth for new hires also gives a sense of where wages are heading. The Indeed Wage Tracker provides an estimate for this, which is likely to move earlier than negotiated wages. Here, we see a cautious downward trend, which actually began in September of last year. That means that overall compensation growth per employee is set to come in somewhat below the negotiated wage developments as the market starts to turn.

Looking at wages from the employers' point of view also gives interesting insights into where wage growth might be headed in 2024. Historically, non-financial corporates have seen gross value added (a rough measure for revenues) increase more or less in line with the total compensation bill in the eurozone. See chart three. This indicates that when revenue growth slows, businesses slow down growth in total compensation paid. This can be done in two ways, either by shrinking headcount or by reducing average wage growth.

Compensation growth for non-financial corporates is slightly less volatile than growth in revenues, but overall there have been no examples of severe deviation between the two since the start of the time series in 2000. The pandemic threw numbers off – as happened everywhere – but recent quarters are already more in sync again. With inflation falling quickly and real economic activity currently stagnating, the compensation environment for corporates is changing quickly. Annual gross value added growth trended around 10% for most of 2022 but came down to 7.4% in the second quarter of 2023.

Whereas last year, strong price growth and decent volume increases allowed for very high overall compensation growth, 2024 will look very different. We expect nominal growth of corporate value added will drop to between 3% and 4% for 2024, which means that a significant squeeze for compensation growth will occur. As a result, employers might be forced to lay off employees and/or reduce average compensation per employee.

There is an element of chicken and egg here of course. Some would be quick to argue that higher wage growth would also increase pressure on businesses to continue to force through higher prices, which would increase revenues. This risk is clearly present as productivity growth is negative at the moment, which means that unit labour costs – the most common measure of wage cost pressures – can still increase enough to cause price pressures at lower levels of wages. We recognise this as an upside risk to the wage outlook. Still, the economic environment has become markedly weaker in recent quarters and businesses are reporting that it is harder to price through higher costs to the consumers. That makes continued slowing revenue growth a more likely prospect.

All in all, we deem it likely that wage growth will peak before next summer and start to trend down over the course of next year for a number of reasons. The only question is how fast wage growth slows, not whether it will. Given the ECB's rather unsatisfying track record for forecasting inflation, it is not the time yet to publicly discuss the policy implications of such a plateauing of wage growth. This is why the ECB wants to wait for more evidence on how wage growth develops in 2024. The experience of the 1970s, when continued high wage growth allowed inflation to remain far too high for far too long, combined with the recent failures to forecast inflation, is keeping the ECB on high alert. For the time being, the ECB still prefers to err on the side of (too) tight monetary policy, rather than premature easing. However, if we are right and wage growth starts to turn soon, the ECB's current stance would be too restrictive. Once the ECB officially gives the all-clear on wage growth, the door for rate cuts is wide open. Last week, ECB President Christine Lagarde said that rate cuts could not be on the ECB's agenda for the next quarters. While this undermines our call for rate cuts next summer, we look back at comments made by Lagarde at the end of 2021. Back then, she didn't expect ECB rate hikes in 2022.

In Australia, the week began with another sombre update on confidence. The Westpac-MI Consumer Sentiment Index returned to deeply pessimistic levels, down 2.6% to 79.9. The RBA's decision to raise the cash rate was a key factor, as evinced by the sharp fall in sentiment between those surveyed before the decision (83.0) and after (78.2). Cost-of-living pressures and renewed concerns over interest rates point to weak holiday season spending; 40% of households plan to spend less on gifts this Christmas than last. This result is consistent with the family finances and spending on 'major household items' sub-indexes being well below long-run average levels.

The labour market remains a bright-spot amid a gloomy outlook, however. The October labour force survey reported that employment increased by 55,000 (0.4%) in the month and hours worked gained 0.5%. Temporary hiring associated with the 2023 Australian Indigenous Voice referendum may have provided support, but the impact is uncertain.

What remains clear, however, is that Australia's migration boom continues to expand the labour force, the participation rate returning to its post-WWI record high of 67.0% in October, seeing the unemployment rate rise to 3.7% even as employment grew above trend. In the months ahead, a further softening in hours worked is likely before employment experiences a material slowdown below trend.

In-step with the resilience of the labour market, wage outcomes also remain supportive. Q3's 1.3% lift in the wage price index was in line with expectations, but the composition offered some surprises. A larger-than-expected contribution from awards and enterprise bargaining – a consequence of the minimum wage and aged care wage decisions as well as CPI indexation – was offset by a softer outcome from individual bargaining, a segment which tends to be more reactive to labour demand/ supply.

This detail suggests upside risks for aggregate wage growth are limited, increasing the probability of the RBA being able to achieve their aim of preserving the gains made on unemployment since the pandemic while bringing inflation under control – a topic discussed by Westpac Chief Economist Luci Ellis this week.

The latest NAB business survey also continued to report welcome progress regarding inflation. Following a sharp moderation in September, momentum in purchase costs, labour costs and final product prices all continued to ease in October, albeit at a slower pace. These results are within the context of a step-down in business conditions from last year (+13 vs. +25) and weakness in business confidence, the current level below the long-run average (–2 vs. +5).

Moving offshore, US consumer prices were flat in October against expectations for a 0.1% gain, leaving annual inflation at 3.2%yr from 3.7%yr in September. Falling oil prices were the primary cause of the deceleration in the month, although core prices also came in below expectations at 0.2%. Within the core basket, goods prices have, at the margin, declined for five consecutive months. Disinflation also looks to be broadening through services ex-shelter, indicating softer consumer demand and business pricing power. As shelter retreats in coming months, the FOMC's 2.0%yr will come within reach, likely mid-2024.

Retail sales meanwhile were broadly as expected in October, roughly flat for the month and up 2.7%yr. 2023's pattern has been periods of strength followed by a lull. If we are right in expecting GDP growth to slow below trend, sales growth will remain weak through year-end without another acceleration. Savings, real income growth and uncertainty over the outlook are all headwinds.

Despite these developments, commentary from FOMC members remains cautious. Chicago Fed President Goolsbee highlighted the importance of rents to the next leg down in inflation, while San Francisco Fed President Mary Daly warned against prematurely claiming victory over inflation. To manage risks, it is prudent for the FOMC to support term interest rates around current levels into the new year when, on the current trend, the CPI will be much closer to target.

UK consumer prices were also flat in October. Benefitting from 2022's high base – established by strong energy and fuel prices before subsidies took effect – annual inflation also jolted lower in October from 6.7% to 4.6%. Outside energy, substantial progress has been made with goods disinflation; however, services inflation remains sticky, contributing 3.0ppts to the CPI, i.e. two thirds of headline inflation, only 0.2ppts less than September. The Bank of England has said they expect services inflation to remain robust for some time. A meaningful turn must materialise before rates can be cut. Enduring strength in wage growth adds to the uncertainty regarding services inflation. Over the year to September, total wages rose 7.9%yr.

Coming back to Asia, China's October activity data was again mixed. Base effects were favourable for retail sales, the pulse of recent months solid but not strong, 6.9%ytd. Fixed asset investment growth meanwhile continues to be held down by weakness in the property sector, respectively 2.9% and –9.3%ytd. The underlying detail of fixed asset investment ex property remains very positive though, with growth in infrastructure and manufacturing investment holding up. Rumours of significant support for the property sector offer the promise of more balanced investment and improving sentiment amongst households and businesses in 2024 if delivered on by authorities. Our expectation of 5.3% growth in 2023 and 2024 depends on further effective stimulus in the months ahead.

Finally, Japanese GDP fell 0.5%qtr in Q3 driven by weakness in domestic demand. Household consumption declined 0.1%qtr following a 0.9%qtr decline in Q2. Exports increased another 0.5%qtr after a substantial 3.9%qtr increase in Q2, but strength in imports offset much of this gain. These results argue for accommodative fiscal and monetary policy to help mitigate the loss of lost purchasing power experienced by households due to inflation.

Following the devastating earthquake in the High Atlas Mountains on September 8, 2023, which resulted in thousands of fatalities and the destruction of numerous villages, Morocco declined an offer of emergency aid from France. This refusal was the starkest indication yet of the deepening diplomatic rift between France and its former protectorate. For most of 2023, the Moroccan embassy in Paris had been without an ambassador. In March, in response to an attempt by French President Emmanuel Macron to de-escalate tensions, a Moroccan official stated that the "relationship is neither friendly nor good, neither between both governments nor between the Royal palace and the Elysee" – a straightforward, undiplomatic slap in the face of the old power.

To understand the roots of the growing chill in Franco-Moroccan relations, besides recent public disputes, one must consider Morocco's shifting alliances, France's diplomatic challenges and both nations' interactions with Algeria. The disruption of the longtime friendship between France and Morocco likely reflects new geopolitical trends, as evidenced by Paris' diminishing influence in Mali, Burkina Faso and Niger.

Morocco's transformation under the reign of King Mohammed VI – who acceded to the throne in July 1999 after the death of his father, King Hassan II – is striking. From 2000 to 2021, gross domestic product (GDP) per capita has more than doubled, soaring from $1,492 to $3,795. The United Nations Development Programme reports that between 2011 and 2018, the kingdom halved its multidimensional poverty index.

Cities like Tangiers or Casablanca have become modern economic powerhouses thanks to a business-friendly climate, strategic international alliances that draw in foreign direct investment (FDI) and massive efforts to improve youth education. Morocco is steadily establishing itself as an African hub, leveraging its prime position bordering both the Atlantic Ocean and the Mediterranean Sea and increasingly pivoting toward the African continent.

France has benefited from Morocco's development, with the kingdom its top commercial partner in Africa. In 2022, French exports to Morocco amounted to 6.6 billion euros, making France the country's second-largest exporter with a 10 percent market share. French FDI stock in the same year stood at 8.1 billion euros, 30 percent of all FDI, with 1,300 subsidiaries in the kingdom, while Moroccan FDI in France was also notable, with a stock of 1.8 billion euros, up from 370 million euros in 2013.

In light of this robust economic bond, the severity of the diplomatic crisis is particularly puzzling.

A key factor to consider is the waning influence of French diplomatic power. First, its loss of momentum is likely tied to diminished foreign policy independence following Nicolas Sarkozy's decision to rejoin NATO's integrated military command in 2009. Earlier, from the 1960s when General Charles De Gaulle withdrew France from NATO command structures up to Jacques Chirac's firm condemnation of the invasion of Iraq, France's unique diplomatic position held a certain allure for the Global South. By adopting an Atlanticist approach, it forfeited this appeal.

Second, French diplomacy is in a state of crisis due to internal reforms. Two elements are particularly significant: the gradual erosion of the French Foreign Ministry's influence through past decades and President Macron's ambition to further reform diplomacy, allowing any high-ranking civil servant to function as a diplomat. This "de-specialization" of the diplomatic corps is widely viewed as imprudent, as foreign service demands on-the-ground knowledge and a skill set honed through overseas experience.

The outcome has been a centralization of diplomacy in the hands of a small group of decision-makers around the president. Consequently, French diplomacy now suffers from a lack of expertise and is driven by Mr. Macron's impulsive and often overly optimistic actions. His approach has oscillated between clumsiness – as in Algeria in 2021 when he accused the country's leadership of capitalizing on the legacy of the Franco-Algerian war – and naive hopes that dictatorial regimes can easily be transformed.

French diplomacy has struggled to adjust to new global realities. But specific events in Franco-Moroccan relations also shed light on the heightened tensions.

Paris's decision to halve the number of visas issued to Moroccans between October 2021 and December 2022 was met with displeasure in Rabat. The measure, which also applied to Algerians and Tunisians, aimed to pressure these nations to repatriate citizens residing illegally in France. However, the strategy was not particularly effective and even caused logistical issues (with truck drivers, for example).

Morocco's grievances also stem from legal actions initiated against its high-ranking officials in France during the mid-2010s and more recently. As a result, Rabat suspended judicial cooperation with France in 2014-2015.

The situation was further exacerbated in the summer of 2021 when France accused Moroccan intelligence of espionage using Israeli-made Pegasus software. The surveillance allegedly targeted a vast number of individuals, including the Moroccan king, French politicians and President Macron himself. Despite Moroccan authorities denying involvement, the incident strained the relationship between President Macron and King Mohammed VI.

In December 2022, a scandal involving allegations of corruption of European Parliament (EP) officials by Qatar actually also implicated Morocco. Italian EU lawmaker Pier Antonio Panzeri and several associates were linked to Moroccan diplomat Abderrahim Atmoun and Moroccan intelligence, according to investigations by Belgian authorities. The lobbying efforts were reportedly designed to sway the EP in Morocco's favor.

Subsequently, on January 19, 2023, the EP passed a resolution denouncing Morocco for the unfair trial and imprisonment of journalists and regime critics based on what human-rights NGOs called "fabricated evidence." The Moroccan parliament responded on January 23 with a vote to "reconsider its relations with the European Parliament," with Moroccan media insisting that France had influenced the EP's decision.

Western Sahara, a vast territory along North Africa's Atlantic coast, has been the subject of Moroccan sovereignty claims since Spain withdrew in 1973. Rabat's quest for control over the area has been a persistent point of contention with Algeria, which has supported the Sahrawi independence movement, the Polisario Front, since its declaration of independence in 1976. In Rabat, Algeria's support for the Polisario Front is seen as a strategic move to curb Moroccan territorial expansion and secure Algerian access to the Atlantic.

The United Nations, through its mission MINURSO, has sought to mitigate hostilities and has advocated for a self-determination referendum since 1991. As an alternative, Morocco offered "extended autonomy" for the region under Moroccan sovereignty. However, the proposed referendum has stalled, with both sides attempting to sway the demographic balance in their favor, leading to a stalemate. France, while backing the UN's efforts, has historically supported Morocco's position at the UN, countering Algerian-led destabilization attempts.

Things changed in December 2020. United States President Donald Trump, in a complete reversal of the U.S. position, recognized Morocco's sovereignty over Western Sahara in exchange for its signing of the Abraham Accords on Arab-Israeli normalization. Some 60 other countries, including Germany, Spain and Israel, followed suit. But not France.

It gave Rabat more leeway, and it more openly supported self-determination of the Algerian province of Kabylia. Algiers broke its diplomatic relations with Rabat in December 2021. In a speech in August 2022, King Mohammed VI stated that the Western Sahara question was "the prism through which Morocco considers its international environment and … the measure of sincerity of friendships and the efficiency of partnerships it would establish." The message was clearly aimed at France.

French leadership may have an ulterior motive in their dealings with Morocco, aiming to curb its ascent. The French elite might harbor discomfort over the emergence of their former protectorate as an independent and assertive player on the international stage, particularly in light of Morocco's burgeoning ties with the U.S. and its strengthened security relationship with Israel.

Morocco's critics occasionally label it a "narco state" due to its significant production of cannabis, a major source for European markets. Positioned at the northern gateway to Africa at the Strait of Gibraltar, Morocco is also perceived by some as leveraging its strategic location as a bargaining chip in managing migrant flows to Europe.