Posts tagged European Union
Some foreign words don’t have English translations that do them justice. Take the German “Schadenfreude,” for example. “Delight at the expense of another’s misfortune” just doesn’t quite pack the same punch. The Russian word “smutnoye” also defies a succinct English counterpart to fully import its meaning. Confusion, vagueness, a troubling sense that something nasty but not quite definable is lurking out there in the fog…these sentiments only partly get at the gist of the word. Russians, who over the course of their history have grown quite used to the presence of a potential fog-shrouded malignance out there in the fields, apply the term “smutnoye” to anything from awkward social encounters, to leadership vacuums in government, to drought-induced mass famines.
Who’s In Control?
We introduce the term “smutnoye” to this article not for an idle linguistic digression but because it seems appropriate to the lack of clarity about where we are in the course of the current economic cycle, and what policies central banks deem appropriate for these times. Recall that, just before the end of the second quarter, ECB chief Mario Draghi upended global bond markets with some musings on the pace of the Eurozone recovery and the notion that fiscal stimulus, like all good things in life, doesn’t last forever. Bond yields around the world jumped, with German 10-year Bunds leading the way as shown in the chart below.
At the time we were skeptical that Draghi’s comments signified some kind of sea change in central bank thinking (see our commentary for that week here). But bond yields kept going up in near-linear fashion, only pulling back a bit after Janet Yellen’s somewhat more dovish testimony to the US Congress earlier this week. And it has not just been the Fed and the ECB: hints of a change in thinking at the apex of the monetary policy world can be discerned in the UK and Canada as well. The sense many have is that central bankers want to wrest some control away from what they see as an overly complacent market. That, according to this view, is what motivated Draghi’s comments and what has credit market kibitzers focused like lasers on what words will flow forth from his mouth at the annual central bank confab in Jackson Hole next month.
Hard Data Doves
In that battle for control, and notwithstanding the recent ado in intermediate term credit yields, the markets still seem to be putting their money on the doves. The Fed funds futures index, a metric for tracking policy expectations, currently shows a less than 50 percent likelihood of a further rate hike this year, either in September or later – even though investors know full well that the Fed wants to follow through with one. Does that reflect complacency? A look at the hard data – particularly in regard to prices and wages – suggests common sense more than it does complacency. Two more headline data points released today add further weight to the view that another rate hike on the heels of June’s increase would be misguided.
US consumer prices came in below expectations, with the core (ex food & energy) CPI gaining 0.1 percent (versus the expected 0.2 percent) on the month, translating to a year-on-year gain of 1.7 percent. Retail sales also disappointed for what seems like the umpteenth time this year. The so-called control group (which excludes the volatile sectors of auto, gasoline and building materials) declined slightly versus an expected gain of 0.5 percent. These latest readings pile on top of last month’s tepid 1.4 percent gain in the personal consumer expenditure (PCE) index, the Fed’s preferred inflation gauge, and a string of earlier readings of a similarly downbeat nature.
Why Is This Cycle Different from All Other Cycles?
In her testimony to Congress this week, Yellen made reference to the persistence of below-trend inflation. The Fed’s basic policy stance on inflation has been that the lull is temporary and that prices are expected to recover and sustain those 2 percent targets. But Yellen admitted on Wednesday that there may be other, as-yet unclear reasons why prices (and employee wages) are staying lower for longer than an unemployment rate in the mid-4 percent range would normally suggest. This admission suggests that the Fed itself is not entirely clear as to where we actually are in the course of the economic recovery cycle that is in its ninth year and counting.
Equity markets have done a remarkable job at shrugging off this lack of clarity. Perhaps, like those Russian peasants of old, they are more focused on maximizing gain from the plot of land right under their noses while ignoring the slowly encroaching fog. Perhaps the fog will lift, revealing reason anew to believe a new growth phase lies ahead. All that remains to be seen; in the meantime, “smutnoye” remains the word of the moment.
Ah, to be alive at a time when “hey, did that really just happen?” can be the go-to phrase of any given day. To be perfectly honest, we did not give much more than a perfunctory review to the news some time back that UK prime minister Theresa May was calling a snap election in a bid to strengthen her Tory Party’s majority in Parliament. May’s insistent mantra of “steady and calm” seemed much more in keeping with the mood of the moment than the unpredictable antics of Labor leader Jeremy Corbyn, unloved even by much of his own party’s senior figures.
But while the good citizens of Washington, DC were filling up the local bars at 10 am for the much-hyped James Comey testimony, our British friends across the pond went to the polls and delivered yet another insouciant slap in the face of conventional wisdom. May’s Conservatives failed to gain a parliamentary majority, while Corbyn’s Labor Party bagged a sizable number of new seats and all sorts of other counterintuitive things happened… suffice it to say that “Democratic Union Party of Northern Ireland” was probably NOT on the tip of your tongue before now.
Does Someone Need a Time Out?
As of this moment the only hard data point we can affirm is that Britain has a “hung parliament,” meaning that no single party has a majority of seats from which to form a government. The most likely outcome, from the initial flurry of horse trading, will be a coalition between the Tories and Northern Ireland’s DUP, which also picked up a couple seats on Thursday night. But that is not definite; observers expect at least an attempt by Labor to form its own coalition. May’s own future as head of her party is anything but certain, and there is a better than average chance we will see another election called before the end of the year.
What this means for Brexit is also spectacularly unclear. What seems apparent, though, is that the “hard Brexit” approach favored by May, expressed by the sentiment that no deal (i.e. a nasty divorce) is better than a bad deal, is headed for the dustbin of history. Brexit is not off the table – Article 50 has been invoked and the game is afoot – but in the fog of confusion produced by the election outcome, some kind of a time-out may be in the cards.
L’Europe, En Marche!
Britain’s position vis à vis Article 50 negotiations is made more difficult still by the marked contrast of fortunes across the Channel. In his brief tour of duty as France’s president Emmanuel Macron has established himself as a strong leader whose En Marche (forward!) party – which did not even exist 14 months ago – is positioned to capture an historic majority of parliamentary seats in this weekend’s upcoming regional legislative elections (so many elections, so little time to cover and process them!). The Old Continent, plagued for so long by political sclerosis and the travails of the single currency region, suddenly looks ascendant under the M&M (Merkel & Macron) leadership star.
A stronger economy, though still not equally dispersed among all regions, may help the pro-EU center solidify its recent gains at the expense of far right populism. A more vibrant Europe will likely have the effect of making a decisive Brexit even less appealing to the nearly half of Britons who would still prefer to remain. Now, it is very difficult to tease out any kind of a clear Brexit message from the confusion of Westminster seats gained and lost on Thursday night. But with ten days to go before formal Article 50 negotiations are set to begin, a British negotiating team that has given short shrift to the many complex details to be worked out in the split would be well advised to take a deep breath and – perhaps – buy some additional time before engaging the battle.
It is said that the Battle of Waterloo was won on the playing fields of Eton. Today’s Old Etonians, and their negotiating team peers, would do well to consult instead Sun Tzu -- on when to engage, and when to pull back and reassess.
This year, the month of March will serve up more than an endless succession of college basketball games and unappealing concoctions of green beer. Almost nine months after the surprise vote last summer, the United Kingdom will finally get to show the world what its exit from the European Union may look like as it triggers Article 50, formally kicking off divorce proceedings. Inquiring investors will want to know how this piece of the puzzle may fit into the evolving economic landscape over the coming years. We take stock of where things stand on the cusp of this new phase of the Brexit proceedings.
Here – Catch This
The UK’s economic performance in the second half of 2016 turned out to be not quite what Remain doomsayers predicted. Real GDP growth for the third quarter – the immediate period after the Brexit vote – was twice what the economists had forecast. With a further strong performance in the last quarter, the UK economy ended 2016 with year-on-year real GDP growth of 2.0 percent, the strongest among the world’s developed economies. Not bad for a would-be basket case!
For most of that time period – from July through November – the main growth driver was consumer spending. For whatever combination of reasons – giddy Leavers on a shopping spree right alongside gloomy Remainers stocking up for the apocalypse, maybe? – households let their consumer freak fly. The pattern changed in the last month of the year. A string of impressive reports from the industrial production corner of the economy in December showed that manufacturers finally appeared to be taking advantage of the sharply weaker pound to sell more stuff, including to key non-EU export markets. That in turn has led to talk of a rebalancing. Consumer spending is unlikely to continue at its recent fervid pace as inflation kicks in and wages fail to keep up – a trend that is already underway. If the services sector can pass the baton onto manufacturing, perhaps the UK could continue to overachieve and make a success of Brexit?
Your Check, Monsieur
The Bank of England has now twice raised its 2017 growth estimate for the UK, so maybe there is some cause for optimism (though it is somewhat hard to see how Britain sustains a competitive advantage as manufacturing powerhouse). A strain of optimism has certainly been coursing through policymaker veins. Prime Minister Theresa May has assured her constituents that the UK side of the negotiating table will push for a most favorable outcome and will fight any EU pushback with nerves of steel. Her government has even hinted at a Plan B should negotiations collapse; a sort of “Singapore on the Thames” financial haven with low tax rates and other incentives for global businesses. But there are a number of potentially thorny roadblocks between here and the promised land.
First off will be an unwelcome bill likely to present itself once the UK team shows up in Brussels. In the eyes of EU budget handlers, British liabilities for things ranging from pension scheme contributions to commitments for future spending projects run to about £60 billion. That is a large chunk of change that (for obvious reasons) has been given short shrift by the UK government in its white papers and other communications with the public on Brexit’s likely cost. EU negotiators give every indication they will insist on the settlement of this account as an up-front divorce payment before any further negotiations on market access, tariff holidays etc. can take place. The British side will be unlikely to go along with that, as it will be in their interests to hammer out a comprehensive solution before they think about a reasonable way to settle accounts. So talks could go off the rails before they even get to the serious issues of economic substance.
What if the negotiations fail? Again, that question has gotten very little focus to date but remains a distinct possibility. An animosity-filled parting of ways between the UK and its largest trading partner (worth about £600 billion per year) would likely not be in anybody’s interest. But each side has its own expectations, its own problems and its own unruly constituents not inclined towards compromise. Bear in mind that, ever mindful of the potential outcome of elections on its own territory, the EU side will be wary of showing any kind of blueprint for easy exit.
And there is a larger picture as well; the Brexit negotiations will be going on during a particularly fraught period for world trade. The Trump administration is hell-bent on scrapping multilateral deals and going after what it imagines to be opportunities for bilateral “wins” (using curiously befuddled and plodding scoring metrics like “surplus-good, deficit-bad”). China would love to lure more scorned partners into its Asian Infrastructure Investment Bank and consolidate supremacy in the Pacific. Brexit, then, will be a big part of an even bigger variable: the rapidly changing face of global trade. However this variable winds up affecting asset markets in 2017, it is likely to have a profound effect on growth and living standards for quite some time to come.
Contrarian investors come in all shapes and sizes, but they all share a variation of this basic way of looking at the world: when the crowd looks one way, it pays to look the other. Today there is an undisputed crowd looking one way -- the Trump reflation-infrastructure trade that shows scant signs of fading, despite a bit of a pause in US equity share gains this week. And there are plenty of good reasons -- we believe -- for looking in other directions, the arguments for which we have set out on these pages in weeks past. But where? This week we consider the merits of one of the least popular asset classes in recent times: European equities.
Europe: The Macro Case
On the face of it, there would seem to be not much to recommend Europe from a top-down analysis of the variables at play. Last year’s Brexit vote hangs over the Continent; while the general consensus remains that Britain’s exit will hurt its own economy more than that of Europe’s, the devil will be in the details of how the parties agree to implement Article 50. Plus, of course, the upcoming elections in France and Germany, and the still-potential wild card of early elections in Italy - will shine a light on the fissures created by anti-establishment sentiment. All this while rattled national leaders and EC technocrats listen for the next approaching Scud missile in the form of a late-night tweet from the other side of the Atlantic.
Valid points, all. On the other hand, the economic health of the region is arguably stronger than it has been since the recession began nearly ten years ago. One of the first macro headlines of note this year was a 1.7 percent reading for consumer price inflation in Germany. Additionally, Eurozone producer prices climbed 1.6 percent year-on-year through the end of December last year. A meaningful part of the jump comes from energy prices; nonetheless, building inflationary pressures would seem to indicate that Europe has moved well and truly back from the deflation trap that seemed all but certain to engulf the region just two years ago. Two cheers, perhaps, for Mario Draghi and his knack for jawboning equity and debt markets.
Moreover, while the upcoming elections could indeed put added stress on the integrity of the common currency region, there is a plausible argument to make against that outcome. Consider the French election, where a victory by far-right populist Marine Le Pen would send shock waves to Brussels. Recently the world learned that the til-now front runner in that race, conservative Francois Fillon, is embroiled in a financial scandal involving fake parliamentary jobs for his wife and children. Apparently nepotism is still a cause for scandal over there - who knew?
The knee-jerk reaction to that news would plausibly be fear that Le Pen, running second in the polls, would vaunt to front-runner status. But wait! The Fillon scandal appears to have worked first and foremost to the benefit of Emmanuel Macron, an independent candidate with a moderate center-left platform who has surged to front-runner status. A Macron win would shake up France’s ossified political system, but arguably in a productive way less likely to be a direct threat to Eurozone integrity. Add to that the likelihood of Angela Merkel winning her fourth term later in the year, and suddenly the Great European Crack-up of 2017 looks less probable.
Europe: the Micro Case
What about the bottom-up view? Well, the obvious place to start would be the valuation gap between US shares and their European counterparts. According to Thomson Reuters Datastream, the twelve month forward P/E multiple for the Euro Stoxx 600, a regional benchmark, is less than 15 times. The forward P/E for the S&P 500, on the other hand, is over 17 times. Now, there have been reasons a-plenty to attach higher valuations to US companies in recent years. Nonetheless, when whole asset classes go out of favor there are usually some very good names that get unfairly tarnished with the macro discount brush.
One area where some contrarians may have been seen fishing about recently is for shares of companies with a significant portion of their revenues derived from outside Europe, particularly in North America or China & Southeast Asia. Remember that for every Procter & Gamble there is a Unilever, for every Exxon Mobil a Royal Dutch Shell. And some of the world’s leading industrial materials concerns -- a sector particularly embraced by the Trump trade crowd -- hail from Europe, among them Germany’s Heidelberg Cement and France’s Lafarge. If you really have to play the infrastructure trade, why not play it with more attractively-valued shares?
The Currency Factor
For a dollar-denominated investor, Europe has been a disappointment for many, many years, and one of the main reasons for that has been the secular bull run of the US dollar. The consensus outlook for the dollar remains strong, mostly due to the imagined outcome of a sequence of interest rate hikes in the US while the Eurozone continues to feed its monetary stimulus program. Every percentage gain by the dollar against the euro is a percentage taken away from the price performance of EU shares in local currency terms. For most of the past eight years, that has been a daunting obstacle.
Again, though, if those EU inflation headlines continue into a trend it is likely to, at the least, put upward pressure on intermediate and long benchmark yields in the Eurozone, which in turn would provide some support to the euro. Back in the US, we continue to see the pace of rate increases by the Fed proceeding gradually and below-trend for some time to come (this squares with our view that the tidal wave of net new infrastructure spending is more a creation of hyperactive investor imaginations than actual likely policy in 2017). With the dollar hovering just a few points above euro parity, there is at least a reasonable case to make that the dollar’s bull run may settle back a bit from its recent pace -- indeed, we saw perhaps a preliminary sign of this with the greenback’s weak January trend.
None of this means that European equities are a fat-pitch obvious source of value. But in a world of expensively priced assets, sometimes it pays to get into the heads of the contrarians and see what they are thinking. We will continue to send reports from this corner of the market as we assess alternative opportunities over the coming weeks and months.
It was almost three years ago to the day. On July 1, 2013, Croatia became the 28th country to join the European Union. “Joyous Croatia Joins Europe Amid a Crisis” ran the New York Times headline of that day. The article noted that the accession of the Balkan republic represented a “rare moment of satisfaction” for an EU beset by stagnant economic growth and a chronic financial crisis. Today there is little in the way of satisfaction or joy in Brussels, as Europeans digest the reality that their club is set to shrink in numbers for the first time since representatives from France, West Germany, Italy, Belgium, the Netherlands and Luxembourg met in a sumptuous room in the French foreign ministry in April 1951 to sign the Treaty of Paris. The British have spoken, and they plan to go it alone.
Of Polls and Pain Trades
Longstanding readers of our weekly commentary will be familiar with our general view on event-driven trades, which is easily boiled down to two simple words of advice: do nothing. The Brexit vote is a compelling case in point for this view. One week ago, poll numbers were showing a slight momentum trend towards “Leave,” risk asset markets were pulling back and volatility was up. Then, a new batch of polls over last weekend suggested that momentum was shifting back towards “Remain,” perhaps in the wake of the brutal shooting of Labor parliamentarian and strong Remain supporter Jo Cox. The momentum shifts in both cases were fairly tempered, with most poll-of-polls composites showing a likely outcome within statistical margins of error either way.
Of course, that did not stop the punters from placing their bets. As the week progressed those bets – now skewed heavily towards a “Remain” outcome, looked more and more like a sure thing. As markets closed for trading on Thursday, the odds as reflected in financial betting markets were over 95 percent for Remain (despite the fact that actual polls still showed nothing remotely that convincing). Global equities closed sharply higher, as did the pound sterling. Then the results came out. There will be pain trades aplenty today, and hopefully a useful reminder about the non-existence of free lunches. Sometimes “do nothing” really is the most prudent course of action.
There is still much that is unknown about the economic impact of Brexit; first and foremost, what specific kind of relationship the UK will have with the Continent going forward. Will Britain be part of a free trade area framework similar to what Norway has with the EU now? Or will there be some kind of customs arrangement for certain goods and/or services, similar to Turkey’s current arrangement? Or something altogether different? There would appear to be plenty of free-lunch thinking among Leave supporters who imagine they can somehow benefit from favorable trade with the EU while restricting the free movement of people (anti-immigration being perhaps the strongest motivating sentiment behind Brexit). Much was promised by the Leave campaign of a highly questionable nature.
That thinking is likely to be disabused by EU negotiators not inclined to be overly accommodating, lest Britain’s example set the stage for further referenda (chatter about France and a “Frexit” lit up the Twitterverse almost instantaneously following last night’s outcome). Article 50 of the Treaty of Lisbon sets forth (very briefly) the terms of disengagement from the union; at this point, all that is clear is that the time frame for leaving is two years. We don’t even know who Britain’s point person in the negotiations will be, as current prime minister David Cameron intends to step down in October. All of which is to say – we would caution against getting too deep into any one particular scenario ahead of even knowing opening gambits on the key issue of ongoing coexistence.
The View from the Corridor
Meanwhile, even today’s frothy market of pain trades and a spike in the VIX volatility index may not drive the S&P 500 below the floor of the corridor where it has been stuck for more than twenty months. So far, at least, the pullback in stocks is relatively contained while bond yields and currencies have also settled down from the more frenetic activity levels seen earlier in Europe, before US markets opened. There is essentially no doubt that central banks the world over are prepared to flood the markets with as much liquidity as they think necessary to stave off a collapse in asset prices (Fed funds futures markets, however improbably, even allow for a 10 percent chance that the FOMC’s next move will be a rate cut). The policy floor is firmly in place. Meanwhile, the next several months may prove even tougher for stocks on the upside, if uncertainty in Europe sets the stage for another strong run by the US dollar. We were just starting to see more corporate management teams gently guide sales and earnings up in expectation of more forgiving currency conditions. Stiffer currency headwinds imply more resistance at the valuation ceiling.
These conditions may change, of course, and we will be closely following the nuts and bolts of how Brexit plays out in the coming weeks. For now, though, we are comfortable with where our portfolios are positioned. We maintained a somewhat more defensive than usual position even as asset markets rallied strongly in March and April, with underweight positions in small caps and non-US stocks while favoring higher quality, dividend-paying large caps. We continue to maintain a modest cash buffer to augment a fixed income allocation of mostly high quality short and intermediate durations. That persistent corridor serves as a useful metaphor in our opinion: neither is it time to go into a super-defensive crouch, nor to let the bulls run rampant. Stay in, but stay cautious.