Posts tagged Geopolitics & Markets
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.
There are weeks when covering financial markets is interesting and engaging, where all sorts of macroeconomic variables and corporate business models demand analysis and discerning judgment for their potential impact on asset prices. And then there are weeks like this week, when none of those things seem to matter. “OMG Trump’s going to start a trade war and everything is going to be terrible” frets Ms. Market, just before the opening bell at 9:30 am. “No, silly, nothing’s going to happen, it’s just boys being boys, talking tough as always” say Ms. Market’s girlfriends while taking away her double espresso and offering some soothing chamomile tea instead. And so it goes, back and forth, up and down, day after tiresome day.
Soya Bean Farmers for Trump
We continue to believe that an all-out trade war between the US and its major trading partners is an unlikely scenario. But it has now been just shy of two months since the first announcement by the US administration of proposed new tariffs on steel and aluminum. The war of words, at least, shows no sign of fading into the background. Attention must be paid.
Moreover, the contours of the dispute have narrowed and hardened. Recall that the original steel and aluminum tariffs were comprehensive, drawing responses from all major trading partners. This week’s tough trade talk has been a much more bilateral affair between the US and China, starting with the formalization of $50 billion in new tariffs announced by the US on April 2. China promptly responded with its own countermeasures: $50 billion including major US exports like soya beans – a move that would go straight to the wallets of farmers in Trump-friendly rural America. Now here we are, on Friday morning, with the stakes raised to $100 billion after the latest US White House release. $100 billion represents about 20 percent of the total value of US imports from China. It would necessarily include many of the consumer products Americans buy – potentially suggesting a catalyst for higher inflation.
What Are Words For?
The message from the administration’s policy voices, such as they exist, to world markets has been essentially this: ignore our blustery words, they’re just harmless morsels of red meat for our rabid political base. All these tariff proposals, according to this line of thought, are just opening gambits for negotiation. Nobody really wants a trade war. This message was persuasive enough to bring Ms. Market out of her early morning funk on Wednesday. What was shaping up to be another one of those disheartening two percent-plus intraday plunges reversed course and finished north of one percent in the green column. We’ll see if the sweet talk is able to work its magic again today, with the S&P 500 back on the fainting couch during morning trading.
The other reason why markets may be inclined to not read too much into the playground tough talk is that actually executing a trade war would be far more complex than simply reading off lists of products and associated tariffs. The global economy truly is interlocked. What this means in practice is that trade is not anywhere nearly as simple as “China makes X, US makes Y and Germany makes Z.” Companies have invested billions upon billions of dollars in intricate value chains that start with basic raw inputs, go through multiple levels of manufacturing, wholesaling and retailing, and involve many different countries throughout the process. Dismantling these value chains, while theoretically possible, would result in an economy barely recognizable to the employees and consumers who have become used to them.
The earnings season for the first quarter is about to get underway, and it looks to be a barnstormer. FactSet, a research company, estimates that earnings per share for S&P 500 companies will grow around 17 percent year-over-year on average, which would make it the strongest quarter in more than 5 years (and, rationally, provide a nice tailwind for stock price valuations). The vast majority of these companies have absolutely no interest in being conscripted as foot soldiers in a trade war, and they will be sure to make their voices heard through plenty of influential lobbying channels. On the US side, at least, there is nothing remotely like a unified “team” suited up to do trade battle – and if they were to push the envelope further, they would almost certainly encounter more unity and clarity of purpose on the Chinese side.
In the end, the trade hawks in the administration may find a way to make do with a few cosmetic, harmless face-saving “wins” while quietly retreating from the battlefield. Meanwhile, though, we may have to put up with a few more of these irrational weeks in the market. Oh well. At least it’s springtime.
History is simply a collection of the biographies of great people, the charismatic heroes and anti-heroes whose supreme self-confidence, fanatical drive and decisiveness write the chapters of the ages. So believed Thomas Carlyle, the 19th century Scottish philosopher and historian who penned works on Napoleon, Frederick II of Prussia and a “Great Man Theory of History” in general.
Or, history is actually not that at all. History enslaves all humankind, great and small alike, to bit-player roles in a complexity of events, near-events and non-events that evolve in ways unfathomable and inaccessible to simplistic storytelling. So believed the great Russian writer Tolstoy, who devoted over 1,000 pages to a novel, War and Peace, to make this point.
To read War and Peace is to read of the cacophony of random events, missed communications, uninformed decisions and human behavioral traps that ultimately shaped events like the battles of Austerlitz and Borodino – not the genius of Napoleon, nor the resolve of Tsar Alexander I, but those thousands of probable and improbable things that had nothing to do with the supposed destinies of great men. “The tsar” wrote Tolstoy “is but a slave to history.” Outcomes have as much to do with weird supply-line hiccups, melting ice on river crossings and rioting prisoners as they do with those bold commands from the top generals.
Tolstoians Under Fire
Investment markets have been in a decidedly Tolstoian frame of mind for several years now. This view aligns with an understanding of the global economy as its own inscrutable, constantly evolving sea of complexity wherein rulers of nations and titans of industry float and bob like tiny specks on the surface. Geopolitical flare-ups happen; currency crises spring up in the Eurozone, citizens vote in seemingly irrational ways, but the global economy just keeps on keeping on. Real GDP keeps growing, corporate earnings grow even faster, job markets and consumer prices reassure us that there are no nasty recessions lurking around the corner. This mindset reached its high point in 2017, when volatility reached historically low levels no matter how crazy, dire or improbable the news of the day.
But this Tolstoian view has run into some stiff headwinds among investors in early 2018. There seems to be a newfound sense, among many, that humans vested with considerable power can, in fact, make consequential decisions that directly impact the value of portfolios of risk assets. The specific catalyst bringing out investors’ inner Carlyle is the growing threat of a trade war. Thursday’s reversal of 2.5 percent on major benchmark indexes was driven in large part by the latest show of bellicosity by the Trump administration and threats of retaliation by China, currently the primary intended target of a new round of punitive tariffs. Investors who were hoping for a quick V-shaped recovery from the original sell-off a few weeks ago can blame that original announcement of new tariffs on aluminum and steel for cutting off the nascent recovery in share prices.
Great (by which we mean “vested with lots of power,” not to be confused with “good”) leaders making bad decisions: a Carlyle-esque reprise of that ill-fated summer of 1914? Or, ultimately, a brief tempest that sooner or later will fall back into an inconsequential ripple on the ever-expanding sea of the global economy? Your own view of markets in 2018 may well be shaped by whether you are more inclined to agree with Carlyle or with Tolstoy.
The Corporate America Variable
If Trump and his inner circle continue to raise the stakes on a trade war, they will be due for an earful from many corners of Corporate America for whom such an outcome is the very opposite of their business growth models. S&P 500 corporations derive in the aggregate more than half their revenues from outside the US. Almost any major company that produces a good or service with a viable market in China is focused on that market for a considerable amount of its potential future growth. This doesn’t just apply to the obvious names of retailers like Starbucks, Nike and Yum! Brands that have been in that market for years, but to firms in any industry from property & casualty insurance to pediatric nutrition to semiconductors. Sure, steel producers may cheer the prospects for protective tariffs in the short run, but their collective market cap weight is considerably less than that of those who forcefully champion more open trade.
So what will it be? Is the global economy, the creation of millions of random interactions of events and non-events and near-events over the past four decades, destined to simply keep evolving, too massive and too necessary in its current form for a sudden reversal into autarkic nation-states waging economic war on each other? Our general inclination is to take a Tolstoian view of things, and we think it likelier than not that the threat of $60 or even $100 billion in punitive tariffs and associated bellicose posturing will not have the power to topple a global economy worth more, in nominal GDP, than $85 trillion.
That is not to say that we have a Panglossian “best of all possible worlds” take on things. Tolstoy never said that history always works out for the best. Sometimes those random, incoherent things that happen or that don’t happen lead to unhappy outcomes – see 1914, 1917 and 1933 as examples of this in the last century. Disciplined investing requires keeping emotions in check, but it also requires us to not rule out improbable, but possible, scenarios.
Longtime readers of our research and commentary know that we spend quite a bit of time dwelling on the economic metric of productivity. Our reason for that is straightforward: in the long run, productivity is the only way for an economy to grow in a way that improves living standards. Curiously, the quarterly report on productivity issued by the Bureau of Labor Statistics generally fails to grab the kind of headlines the financial media readily accord to unemployment, inflation or GDP growth. So there is an excellent chance that today’s release showing a drop of 0.1 percent in productivity growth for Q4 2017 (and a downward revision for the Q3 number) didn’t show up in your daily news digest. And while one quarter’s worth of data does not a trend make, the anemic Q4 reading fits in with a larger question that bedevils economists; namely, whether all the innovation bubbling around in the world’s high tech labs will ever percolate up to deliver a new wave of faster growth.
Diminishing Returns or Calm Before the Wave?
The chart below shows the growth rate of US productivity over the past twenty years. A burst of relatively high productivity in the late 1990s and early 2000s faded into mediocrity as the decade wore on. After the distortions (trough and recovery) of the 2007-09 recession, the subsequent pattern has for the most part even failed to live up to that mid-2000s mediocrity.
There are two main schools of thought out there about why productivity growth has been so lackluster for the past 15 years. The first we could call the “secular stagnation” view, which is the idea that we have settled into a permanently lower rate of growth than that of the heyday of 25 years or so following the Second World War. The second school of thought is the “catch-up” argument, which says that scientific innovations need time before their charms fully work their way into the real economy. Readers of our annual market outlooks may recall that we closely examined the secular stagnation argument back in early 2016, while the catch-up philosophy occupies several pages of the 2018 outlook we published last week.
The most persuasive evidence made by the catch-up crowd is that both previous productivity waves – that of the late ‘90s – early 00s shown in the above chart and the longer “scale wave” that ran from the late 1940s to the late 1960s – happened years after the invention of the scientific innovations that powered them. Most economists ascribe a significant impact to the products of the Information Age – hardware, software and network communications – in explaining the late 1990s wave. But those products started to show up in business offices back in the early 1980s – it took time for them to make an actual impact. According to this logic, it should not be surprising that the potentially momentous implications of artificial intelligence, deep machine learning, quantum computing and the like have yet to show that they make a real difference when it comes to economic growth.
Productivity and Inflation
The economic implications of productivity tend to be longer term rather than immediate – that is probably why they don’t merit much coverage on the evening news when the BLS numbers come out. After all, the economy is not going to stop growing tomorrow; nor will millions of jobs disappear in one day if another productivity wave comes along with the potential to make all sorts of service sector jobs redundant (a point we make in our 2018 outlook if you’re interested). The lack of immediacy can make productivity debates seem more like armchair theory than like practical analysis.
But productivity (or its lack) does have a lot to do with a headline number very much in the front and center of the daily discourse: inflation. What the BLS is reporting in the chart above is labor productivity: in other words, the relationship between how much stuff the economy produces and how much it costs to pay for the labor that produces that stuff. If compensation (wages and salaries) goes up, while economic output goes up by a smaller amount, then effectively you have more money chasing fewer goods and services – which is also the textbook definition of inflation.
In fact, the BLS notes in its Q4 productivity release that higher compensation was indeed the driving factor behind this quarter’s lower productivity number. Bear in mind that unemployment is currently hovering around the 4 percent level (this is being written before the latest jobs report due out Friday morning), and anecdotal evidence of upward wage pressures is building. An upward trend in unit labor costs (the ratio between compensation and productivity) has the potential to catalyze inflationary pressures.
Keep all this in mind as we watch the 10-year Treasury inch ever closer towards 3 percent. As we noted in our annual outlook, it makes sense to watch the bond market to understand where stocks might be going. And anything related to inflation bears close monitoring to understand what might be happening in the bond market.