Posts tagged European Union
Any mention of the European Union in recent days is likely to elicit a bemused shake of the head at the inexplicable ineptness of the entire British government as it dithers over how to dig itself out of the hole its leaders dug for themselves three years ago in deciding to have a referendum on Brexit (we will take this opportunity to reaffirm the prediction we made back in the fall of last year: Brexit will get delayed, then delayed again, and eventually will get put to a referendum and not happen, which is also apparently what investors in the British pound sterling think). But while the world looks on at the impasse between the Continent and those on the other side of the Channel, there is something of potentially larger significance for the EU in the long term. That something is bubbling up in Italy.
On March 22 the Italian government intends to sign a memorandum of understanding with China to participate in the Belt and Road Initiative under the auspices of a package of loans from the Asian Infrastructure Development Bank (AIIB). The signing will take place in conjunction with the visit to Rome by Chinese president Xi Jinping, and it brings a whole slew of testy geopolitical issues right into the heart of the single currency union. Italy is technically in recession, with what is now the second-highest unemployment rate in Europe, and increasingly receptive to China’s attempts to insinuate itself into the nation’s economic and political system.
On the surface of it, things don’t look all that dire from a financial markets perspective. Investors have been pouring into Italy in the opening weeks of 2019. The chart below shows the spread between benchmark Italian 10-year bonds and their German Bund equivalents, which has come down considerably after spiking at several junctures in 2018.
Italian paper now trades at yields around 100 basis points less than last year’s peak. That is hardly a sign of investor confidence in Rome, however, and more a manifestation of this economic cycle’s longstanding obsession: chasing yield. That obsession turned stronger still with last week’s pivot by the European Central Bank back to stimulus mode. As we noted in our commentary last week, the ECB’s about-face is not good news for a regional economy where growth and productivity have flatlined (productivity, which is the key driver of economic growth, contracted in the Eurozone in both the third and fourth quarter last year by the widest margin since 2009). Italy’s domestic woes, headlined by that poor job market and a fall in industrial production, are at the vanguard of the region’s economic ills.
Follow the Money
The practical significance of Italy’s newfound dalliance with China and the AIIB may not be readily apparent for some time yet. The variables that alter the course of complex systems like the global economy don’t always make themselves known in understandable ways. But the Belt and Road Initiative is arguably the largest and most progressive infrastructure project going on anywhere in the world now. The AIIB – and remember that this is a multilateral financial organization aiming to encroach on the longstanding domain of the International Monetary Fund and the World Bank – makes a point of playing by international rules rather than the more secretive practices of, say, the China Development Bank or the Export-Import Bank of China. Its attraction for struggling countries – including those in both western and eastern Europe – is undeniable.
As Europe continues to wrestle with growth and support its own sources of growth financing, it will become ever harder to resist China’s siren song. And that has profound implications for maintaining unity and cohesion within the EU – more profound, perhaps, than even the sorry farce of Brexit.
How do you tell whether someone is a novice investor or a seasoned observer of the ways of the capital markets? Simply pose a question like the following: “Growth data show a marked slowdown in economic activity in key economic regions like China and the European Union. Good or bad for global equities?”
“Bad!” says the novice. “Low growth means a poor outlook for companies’ sales and earnings, and that should be bad for the stock price, right?”
To which the seasoned pro chortles a bit and ruefully shakes his head. “Let me tell you how the world really works, kiddo. That low growth number? That’s good news! It means the central banks are going to prime the pump again and flood the world with cheap money. Interest rates will go down, stocks will go up. Easy as ABC!”
Down Is Up
The logic of “bad news is good news” has been a constant feature of the current economic growth cycle since it began in 2009 (and, barring any surprises, will become the longest on record come July of this year). The key economic variable of this period has not been any of the usual macro headline numbers: real GDP growth, inflation or unemployment. It has been the historically unprecedented low level of interest rates.
Short term rates in the US were next to zero for much of this cycle, with persistent negative rates (a phenomenon which itself flies in the face of conventional economic theory) in Europe and Japan. Central banks argued that their unconventional policies were necessary to restore confidence in risk assets and stimulate credit creation for the benefit of consumer spending and business investment. The evidence would seem to support the bankers’ view, as growth started to creep back towards historical trend rates while labor markets firmed up in most areas. The Fed has drawn its share of criticism for the easy money policies of quantitative easing (QE) from 2009 to 2015 -- but the Bernanke-Yellen-Powell triumvirate will forever be associated with the phrase “longest economic recovery on record” when that July milestone is reached.
Draghi Speaks, Markets Balk
But to return to that conversation between our novice investor and seasoned stock pro: Does “bad news is good news” always work? Is there a point at which the magical elixir of monetary stimulus fails to counter the negative effects of a slowing economy? That is a question of particular interest this week. On Thursday, the European Central Bank (ECB) backed away from its attempt to wean markets off easy money when it reopened the Targeted Longer-Term Refinancing Operations, a stimulus program to provide cheap loans to banks, for the first time in three years. ECB chief Mario Draghi made it clear that the catalyst for this return to stimulus was the steadily worsening outlook for EU economic growth.
This time, though, markets failed to follow the “bad is good” script and reacted more the way our novice investor would think makes sense: selling off in the face of a likely persistence of economic weakness. Italy is already in recession, Germany is only barely in growth territory, and demand in the major export markets for leading EU businesses is weakening, most notably in China. That economy, the world’s second largest, has its own share of problems. A record drop in Chinese exports -- far worse than consensus expectations -- sent Chinese shares plunging overnight Thursday. Other Asian export powerhouses including South Korea and Japan are also experiencing persistent weakness in outbound activity.
Pivot to Fundamentals
In our annual outlook published back in January we noted that weakness in Europe and China was prominent among the X-factors that could throw a wrench into markets in 2019. For much of the time since then it has not seemed to be much of a factor. World equity markets bounced off their miserable December performance in a relief rally driven by the “bad is good” logic of a dovish pivot by central banks, underscored formally by the Fed in late January.
But the market’s underwhelming response to the ECB on Thursday, amid a vortex of troubled headline data points that now includes a tepid US February jobs report, suggests that real economic activity may be starting to matter again. In just a few weeks we will start to see corporate sales & earnings numbers for the first quarter, which consensus expectations suggest could be negative for the first time since 2016. Shortly after that will come Q1 real GDP growth, which analysts are figuring could be in the range of one percent. All this could suggest more of that volatility we predicted would be a primary characteristic of 2019 risk asset markets.
Our novice investor of that earlier conversation may not be schooled in the ways of markets, but she made one salient point. Low growth should mean a poor outlook for company sales and earnings. Those sales and earnings, in the long run, are all that really matters, because a share price is fundamentally nothing more and nothing less than a net present value expression of all that company’s future cash flows. Perhaps the time is at hand when this long-term truth will actually have an impact on the market’s near-term directional trends.
It wasn’t all that long ago that Davos Week was a big deal. Confident, important communiqués about the state of the world delivered by important, impeccably tailored men (and a few women here and there). The rest of the world’s inhabitants might live out their quotidian habits in a perpetual fog, but the great and good who assembled in the little Swiss Alpine town every January were there to tell us that it was all going to be okay, that the wonders of the global wealth machine would soon be trickling their way. Now the fog has enshrouded them as well. While their status as influencers was getting sucked down into the lowest-common-denominator Twitterverse, their ability to explain the great trends of the day was upended by the improbable turn those trends were taking away from the comfortable Washington Consensus globalism of years past. “The mood here is subdued, cautious and apprehensive” reports Washington Post columnist (and Davos Man in good standing) Fareed Zakaria from the snowy slopes this year. Apprehensive, not confident, which is an apt way to sum up the present mindset of the world.
Never Underestimate the Power of Kick the Can
Yet, for all the fretting and fussing among the stewards of the world’s wealth pile, some of the key risks that have been plaguing investors in recent weeks seem to be turning rather benign. Consider as Exhibit A the state of the British pound, shown versus the US dollar in the chart below.
The pound has rallied strongly since plummeting in early December last year. If you go back and track the history of Brexit negotiations since that time, you find that the actual news about a Brexit resolution is almost all dismal. The deal PM Theresa May brought back from Brussels was panned as soon as it reached Westminster; that same deal formally went down to one of the most ignominious defeats in UK parliamentary history last week.
All the while – the pound sterling has rallied! Why? Because the Brexit deal’s unpopularity means that there are only two ways this whole sorry affair plays out between now and March, when the Article 50 deadline comes into effect. One is that the UK crashes hard out of the EU, which would be a disaster for the country. The other – and far and away the most likely, is to kick the can down the road. Extend the Article 50 deadline, probably to the end of the year, and see what kind of fudge can be worked out between now and then. Maybe (most likely, as we have been saying for some time now) a second referendum that scotches Brexit for once and all. Maybe something else. Maybe someone has to make a bold decision at some point. But not yet, not yet, as that fellow said in “Gladiator.” Thus the strong pound.
March Without the Madness
The month of March has in fact been looming large over Davos think-fests and cocktail parties this week. In addition to Article 50, there is that self-imposed deadline by Washington’s trade warriors to reach some kind of deal with China on the terms of cooperation going forward – absent which, according to Trump’s protectionist acolytes, there would be hell to pay in the form of new tariffs. Yet as the days go on, the evidence mounts that this administration’s tough talk on any number of fronts is all hat and no cowboy. This administration has plenty of other troubles with which to contend, and by now they know that actually following through with tough trade rhetoric will spark another pullback in the stock market. We don’t think it’s being Pollyanna to say that this trade showdown at high noon will likely not come to pass.
Finally, the other risk event that could befall markets after the Ides of March would be the Fed meeting that month with the potential for another interest rate hike. While that is a possibility, the Fed’s actions in recent weeks have been very cautious and non-confrontational with edgy markets. Recent inflation numbers have come in a bit below expectations. We’ll see what happens with Q4 GDP next week, but indications are that it will settle back somewhere in the 2-plus percent real growth range. In other words, the Fed will have plenty of flexibility if it decides to join in with the kick the can fun and hold off until next time. Even on the question of the Fed’s balance sheet there have been some recent indications that it may not wind down as quickly or deeply as previously thought.
“Never make tough decisions today that you can punt down the field for later” – this instinct is alive and well in the world of global policymaking. As long as that remains the case, Davos Man, you should take a deep breath and go back to enjoying your cocktails and canapés.
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.