Posts tagged European Union
It’s not Thanksgiving week over in London, but British prime minister Theresa May is likely in a mood to give thanks anyway. The object of May’s thankfulness would be the spectacle of hardline Eurosceptics in her own Tory party, led by the decidedly odd duo of Boris Johnson and Jacob Rees-Mogg, doing their best impression of a rafter of turkeys cluelessly scampering this way and that in a ham-fisted effort to unseat the PM and torpedo the much-unloved Brexit deal she is trying to sell to Parliament.
A Comedy of Errors
The tragi-comical mess that is Brexit has percolated in and out of the news since the referendum nearly two and a half years ago produced the shocking (at the time, not so much any more) decision to quit the EU. With the Article 50 deadline of March 2019 looming, the recent headlines have been decidedly unkind to just about anyone involved with the negotiation process, most of all from the UK side. Concerns about the potential global impact of a no-deal crash-out from the EU have joined other festering concerns – about tech stocks, interest rates, China and others – to keep market sentiment on the side of risk-off. As we write this, the S&P 500 is hovering just at the technical correction threshold of a 10 percent decline from its last high (reached on September 20). If the May government collapses in the coming weeks, which is not a zero-probability event, then confidence may be shaken further still.
Under the frothy headlines, though, there is at least a case to make that the worst outcome will be avoided. Amid all else going on in the world right now, we think it is worth one’s time to understand where things currently stand on Brexit and why they might not be quite as dire as they seem – why, in other words, Theresa May might truly be in a thankful mood.
The Artlessness of the Deal
Exceedingly few kind words, to be sure, have been penned about the deal currently up for approval. A “rotten prawn” opined British journalist Quentin Letts in a recent Washington Post opinion piece (the piece is also notable for likening PM May to an “Atlantic mollusk” in a way that was actually meant as a compliment). The deal keeps the UK in a threadbare customs union with the EU that at once displeases Remainers (stuck in limbo is worse than being part of the EU) and Leavers (stuck in limbo is worse than the clean break that was voted for in 2016). It gives discretion to Brussels over future decisions about the very contentious and seemingly intractable issue of the Northern Ireland border. In the minds of not a few observers it is nothing short of a transfer of decision-making power on a great many issues from the British Parliament to the European Commission.
The Worst Option, Except for All the Others
Rotten prawn though it may be, the May deal has gained some important sources of support including Bank of England head Mark Carney, leaders in the UK business community and establishment media organs such as the Financial Times and Economist. The common theme being that, as bad as this deal may be, it is infinitely preferable to an abrupt ejection from the EU next March with no Plan B. The real-world implications of a hard, no-deal Brexit have not, in any meaningful way, been manifestly evident to date. The pound sterling today is just 15 percent weaker versus the US dollar than it was right before the Brexit vote happened. The FTSE 100 stock index has gained about 10 percent since June 2016 – much less than the S&P 500, say, but still positive. Headline macroeconomic numbers from jobs to inflation and GDP have also held up reasonably well – again, not going gangbusters but neither going into recession.
A hard Brexit, many believe, would be the end of these relative good times and the beginning of something much worse. The Bank of England plans to back up its support for the May deal next week with a more detailed assessment of the economic consequences of an abrupt Brexit crash-out. Paramount in the minds of those supporting the deal is the transition period it provides – anywhere from two to four years – after Article 50 kicks in next March for both sides to work out a detailed agreement for trade and economic cooperation. Wait, you say, wasn’t that what they were supposed to be doing for the last two years? Fair point – but an “extended transition period” is actually what the EU does best – it kicks the can down the road to be fixed at some future date. Meanwhile, businesses and investors at least have the assurance of continuity for a measurable period of time.
Vox Populi, Redux?
There is a certain cunning logic to that kick-the-can trick in the EU playbook: things can change, maybe to the extent that a final decision on Brexit will never be made. Currently there is quite a bit of chatter in Britain about a so-called “People’s Vote” (good marketing!) that would effectively revisit the entire premise of Brexit. Voters in this scenario would have three options: choose the May deal currently on the table, choose a hard Brexit along the lines of what Johnson, Rees-Mogg and the rest of the Tory turkeys claim to want (the details of which are, to be charitable, foggy), or choose…to stay in the EU. While the notion of a second referendum has been bandied about since the immediate aftermath of the first one, this People’s Vote idea seems to have quite a bit of cross-over support from erstwhile Leavers and Remainers. According to at least one recent poll on the topic, the cohort preferring to remain in the EU was 54 percent. Recall that in the original vote 48 percent supported Remain, 52 percent were for Leave.
So could the whole unseemly mess just go away, like a bad dream that finally dissipates with morning’s light? That would not necessarily be the way to bet, nor would it solve the very real, very partisan divide among Britons about their place in Europe and the world at large. Sadly, we are too far down the road of populism and blinkered, tribal nation-first thinking in too many parts of the world for that toothpaste to go back into the tube. But there are three possible, practical alternatives in front of the UK today. Of the three, one would very likely deliver a great deal of economic pain within a very short period of time. Either of the other two would be far more palatable – and could helpfully reassure global markets that the world’s humans have not yet completely gone off their rockers.
We wish all of you and your families a very happy Thanksgiving.
An up and down week on Wall Street may end on a slightly positive note, if the sentiment we are seeing on this Friday morning makes it through the afternoon. Don’t mistake this for some kind of definitive trend, though – what’s been happening this week is much more about technical buy and sell triggers that send much of the market’s intraday volume hither and yon. At one point earlier this week the S&P 500 actually closed below its 200-day moving average for the first time since early 2016. There’s nothing magical about moving averages, of course, except that lots and lots of trading strategies are programmed to react to them. Perception is reality in the world of short term trading.
In any event, while indexes bounce up and down in search of a driving theme to provide direction for the rest of the year (which we think has a better chance of being up but a not immaterial chance of being down) we want to dig into some of the X-factors contributing to the current frisson of unease. In this week’s commentary we feature the Italian debt market. Spreads between Italian benchmark bonds and German Bunds (the go-to safe haven for EU fixed income) are at their widest levels in four years.
Return of Eurozone Mal de Mer
The above chart shows that Italy-Bund spreads are a useful indicator of unrest in the Eurozone. After ECB chief Mario Draghi assured the world that the Eurozone would stay intact with his “whatever it takes” speech in 2012, the spread tightened from the wide gulf of the crisis years to a more typical risk premium that lasted for most of the past four years. That all changed with the national elections in March 2018, which ended with a populist government sworn in two months later, in May. The coalition government of the Five Star Movement (FSM) and the League, representing different flavors of anti-establishment populism, set out some ambitious plans to deliver on its campaign promises of stimulus measures for growth and jobs. Eventually, these plans found their way into a budget the country is required to submit to EU officials in Brussels, to ensure that the terms are in keeping with EU standards and constraints. Brussels, to put it mildly, was not amused.
EU economics officials routinely issue rebukes to member country policies which they see as deviating from rules – particularly the rules developed during the crisis years earlier this decade. But the language in this Thursday’s communique from Brussels to Italian finance minister Giovanni Tria was – well, practically Trumpian in its histrionic flavor. “Unprecedented in the history” of EU budget rules! – said the stern technocrats. One would think nothing of such a seismic nature had rocked the continent since Charlemagne crushed the Merovingians.
The odd thing is that Brussels’ main sticking point with the budget is its assumption of running a 2.4 percent fiscal deficit. While not inconsiderable, that is a lower fiscal deficit than those run by EU members France and Spain, and it is also lower than what the new Italian government initially planned after the coalition came together in May. The real underlying problem is that few observers believe a fiscal deficit of this size is sustainable for a country challenged by slow economic growth and a cost of debt that is already rising. The bond investors who have been selling off Italian bonds this week anticipate further downgrades to Italian debt from S&P and Moody’s later this month, and expect further headwinds to buffet the fragile condition of large Italian banks.
The bigger contextual picture, of course, goes beyond Italian sovereign debt to the overall health of the EU. There has been little in the way of good news from Europe this year. The Brexit negotiations are an ongoing fiasco painting nobody in a good light. On the eastern periphery Hungary and Poland can fairly be called ex-democracies as their authoritarian governments consolidate one party rule. Italy and Austria are ruled by populists. Establishment darling Emmanuel Macron’s approval ratings in France are an abysmal 33 percent (that’s lower than Trump has ever fallen here back home!). And Germany is also teetering on the dividing edge between populists and technocrats. Witness this past weekend’s regional elections in Bavaria where the long-dominant CSU (the regional partner of Chancellor Merkel’s ruling CDU) suffered its biggest loss of seats in the party’s postwar history.
In this fraught landscape, the notion of a fiscal crisis or banking system collapse in Italy has the potential to inflict more damage than the original Greek economic crisis that led to the dolorous years of 2011-12. Back then those three magic words uttered by ECB chair Draghi – whatever it takes – were enough. We may see proof in the coming weeks, one way or another, whether indeed it is enough.
2011, 2012, 2015…ah, memories of summertime Eurozone crises past. On the cusp of the summer of ’18 it would appear not entirely unreasonable to imagine that we are due for another languid spell of troubled waters across the Atlantic. Political dysfunction in the southern periphery was on full display this week, first with Italy’s fumbling attempt to form a new government and then with a no-confidence vote shoving Spanish PM Mariano Rajoy out of office in favor of Socialist Party leader Pedro Sanchez. Word is that Rajoy sat out the parliamentary hearings leading to his ouster, choosing to spend those eight hours in a Madrid restaurant instead. Respect.
Oh, and the US went ahead and imposed steel and aluminum tariffs on the EU, leading EU trade commissioner Cecilia Malmstrom to pronounce a “closed door” on EU-US trade liberalization talks. Abandon hope, ye bourbon drinkers of Europe. The euro continued its slide while investors hugged onto German Bunds like a Steiff bear, illustrated in the charts below.
The big drama this week, of course, came courtesy of Italian president Sergio Mattarella as he gave a Roman thumbs-down to the cabinet submitted by the recent populist partnership of the Five Star Movement and Northern League (see here for our analysis last month of the implications of this partnership). The move caught investors by surprise and Italian bond yields soared (the blue line in the leftmost chart above).
It may seem counterintuitive that Mattarella’s move sparked a negative market reaction. After all, his opposition to the cabinet slate was focused on the proposed finance minister Paolo Savona, an outspoken critic of the single currency union. The resulting impasse with the FSM/League coalition led to a proposed caretaker government led by Carlo Cottarelli, a former IMF official. That sounds awfully market-friendly…but no, investors read this as a resurgence of the “in or out” question that last reared its head with the Greek financial crisis of July 2015. The thinking was that Mattarella’s technocratic move would give a new tailwind to the Northern League (which indeed has seen a sizable bump in the polls this week) and could result in a more decisive victory for the “out” faction in another round of elections this fall. Suddenly “Quitaly” was the new “Brexit.”
Trouble Ahead, Trouble Behind
The Mattarella tempest resolved itself just in time for markets to breathe a tempered sigh of relief and not pay attention to the no-confidence vote brewing over in Spain. The FSM/League coalition came back with an “acceptable” candidate for finance minister, Giovanni Tria (a political economy professor), Mattarella gave the green light, and all appears ready to proceed apace. Italian assets recovered some lost ground. The can appears safely kicked down the road once again, and now we can all relax and start watching the World Cup, right?
Perhaps not. There are challenges aplenty for this new, not entirely stable coalition government in Italy – on domestic debt levels, on immigration, and – yes – on the general relationship with Brussels, which is hardly amicable to begin with. And while observers don’t see much in the way of market ripples coming from the recent events in Spain, the fact remains that the no-confidence vote there came about due to revelations of political corruption and a slush fund operated by senior members of former PM Rajoy’s Popular Party – another blow to Establishment credibility. The new government led by the Socialists includes an unwieldly array of coalition partners including nationalist Basque and Catalonian factions and the far-left Podemos Party – so there is hardly a unifying ideology there.
In fact, very little about Europe’s political environment looks stable. Nationalist and borderline fascist blocs control much of the eastern periphery of the EU, Germany’s “grand coalition” is struggling, and all the while thorny issues with Brexit persist on the western front. The economy has reverted to slow-growth mode, the ECB is trying to navigate its way out of its monetary stimulus obligations, and now Brussels needs to rally the troops around a united response to those ill-advised US tariffs.
It may be summertime, but the living would appear to be anything but easy.
You may recall, dear reader, that there was a national election in Italy back in March that proved to be highly inconclusive. We’ll give ourselves a modest pat on the back for prognosticating ahead of that event its most likely outcome – a non-decision with power hanging in the balance as ascendant populist parties try to figure out a workable cohabitation while the previous center-left government – here as elsewhere throughout Europe – fades into oblivion. That election returned to occupy market attention this week.
Not This Time
The string of recent elections in Europe that started with the Netherlands and France around this time last year, and continued on into Germany last autumn, managed in each case to avoid a decisive populist surge into power while at the same time underscoring just how unpopular traditional parties there are – particularly those of the once-dominant center-left. At some point, the run of dumb luck was due to come to an end. That seems to have happened. It remains to be seen, though, whether the increasing likelihood of a government variously hostile or (at best) indifferent to the EU and the single currency will unnerve investors. Despite a bit of a hiccup on the Milan bourse (shown in the chart below) and a slight widening of the spread between Italian benchmark bonds and German Bunds, the answer so far is – not much.
Voi Volete Governare?
The question left pending after the March election was whether any such “workable cohabitation” for governing would be possible between the party platforms of the Five Star Movement (FSM) – the creation of a popular comedian, Beppe Grillo, the unifying message of which seems to be nothing more than “throw all the bums out” – and the more ideological Northern League, an ethno-nationalist party with roots in a movement for Italy’s prosperous north to secede from the rest of the country. As early as Tuesday this week that question appeared unresolved, and the chatter turned to the embarrassing possibility of a second election just months after the first.
Send In the Clown
Then, on Wednesday, the contours of Italy’s next government became clearer. Former prime minister and walking evidence for why the #MeToo movement exists, Silvio Berlusconi, gave his tacit blessing to a League-FSM governing union. Berlusconi’s own Forza Italia party underperformed in the March elections, but retained enough clout to give its still-politically viable leader a kingmaker role. The respective leaders of the League and the FSM, Matteo Salvini and Luigi di Maio, have instructed their key staff to reconcile platform positions by the end of the weekend. There is still the possibility that these will not bear fruit, but the consensus among insiders familiar with the process is that the next government of this G-7 nation will be run by a coalition decidedly at odds with Brussels on many important issues ranging from immigration to Eurozone fiscal policy to the need for sanctions against Russia (like many other European populist movements, both the FSM and the League are generally pliant towards Russia and Putin).
Nothing to See Here…Yet
There is a grain or two of rationality in the market’s relative complacency towards Italy. On the bond side, the ongoing presence of the ECB is a strong counterweight against wild fluctuations in yields. The central bank holds about 15 percent of the total float of Eurozone sovereign debt, which creates stability. The return to stagnation in the Eurozone economy (see last week’s commentary) reduces the likelihood that the ECB will move soon in any drastic way to curtail its QE program.
In equity-land, the large cap Italian companies that account for the lion’s share of total tradable market cap are largely multinationals with a diverse geographic footprint and thus less directly exposed to a potential economic downturn in their home market.
The current sense of calm notwithstanding, investors have long wondered whether a populist/nationalist government at the head of one of the major Eurozone nations poses a critical threat to the viability of the single currency region. An answer to that question, one way or the other, may be forthcoming in the months ahead.
Yes, it’s already May. Three days into the year’s fifth month, we are pleased to say we have not yet had to listen to the first seasonal “sell in May and go away” pronouncement by a stupidly grinning CNBC pundit. It’s coming, though, as surely as May flowers follow April showers. Meanwhile, as equities tread water between the support and resistance levels that were the subject of last week’s commentary, we are giving a second look to one of the key drivers of the default macro narrative: the synchronized global growth theme. In the crosshairs of this analysis is the Eurozone. The Cinderella story of 2017, with a growth trajectory in line with that of the US, seems to be morphing back into one of the dowdy stepsisters.
The Return of La Malaise
We’ve been here of course, before. The economy of the single currency zone experienced an existential crisis in 2011 as Greece’s debt debacle threatened to spread to other troubled “periphery” markets like Italy, Spain and Portugal. Mario Draghi brought it back from a near-coma with his “whatever it takes” avowal in June 2012 and the subsequent introduction of the ECB’s quantitative easing program. But growth languished until a surprising run of data last year. Production output, service sector growth, employment and confidence improved across the region. Inflation, which two years earlier seemed poised to sink into a deflation trap, rebounded and made the ECB’s 2 percent target seem almost reasonable. With Japan also joining in the fun, by the second half of last year the world’s major developed economies seemed almost to be growing in lockstep. “Global synchronized growth” became the go-to shorthand for explaining last year’s good times in risk asset markets.
But real Eurozone GDP growth for the first quarter, released yesterday, came in at 0.4 percent, the lowest quarterly figure in eighteen months. Today, the flash estimate of core inflation (excluding the energy and food & beverage sectors) shows consumer prices growing at just 0.7 percent – not exactly within striking distance of that elusive 2 percent target. As this is the first reading of the data, the jury is still out on what is driving the slowdown (or, for that matter, whether this is just a one-off bump in the road or the onset of something more prolonged).
Euro Up, Euro Down
One possible culprit for the return of stagnation is the currency. In December 2016, at the height of the “Trump trade” follies that took control of investor brains, one euro bought just $1.04. Parity was surely around the corner. Instead, the euro went off on a tear, surging to $1.20 by last fall and then as high as $1.25 earlier this year. The simple rule of thumb is that a strong currency is a drag on an economy’s net exports because it makes those exports less price-competitive on world markets. That drag takes time to show up in actual figures, though, so it is possible that a yearlong appreciation of the euro is finally starting to show up in the GDP data.
If currency is the culprit – and we don’t have enough data yet to arrive at a firm conclusion – then we may get a signal in the not too distant future that the stagnation won’t last for long. The dollar has surged against most major currencies, including the euro, since the middle of April. The euro is back down below the $1.20 threshold. The trend reversal is indicated in fairly striking fashion in the chart below. This shows a side-by-side comparison of the MSCI EU equity index in US dollar (left) and euro (right) terms over the last three months.
The “divergence” trade that many had predicted more than a year ago, with a growing gulf between tighter monetary policy in the US and still-accommodative measures in Europe (and Japan) may be coming into its own. A stronger dollar would be a key presumption of the divergence trade, along with widening spreads between US and Eurozone benchmark yields (the 10-year German Bund yield is around 15 percent off its recent high while the 10-year Treasury is close to its highest levels since 2014).
It is quite possible, of course, that the euro’s trajectory is not the main story when it comes to the question of what may be pushing Europe’s economy out of sync with US growth trends. Not much was ever actually fixed following the 2011-12 crisis – most policy issues and questions about member states’ economic obligations to each other were just kicked down the road to be reckoned with later. The time for reckoning may be at hand. Breaking up the “global synchronized growth” narrative is about the last thing an already jittery market environment needs.