The realisation is finally dawning on many in Europe that a No Deal Brexit would hit the EU very hard and is therefore an undesirable outcome. After hoping and wrongly presuming that the UK would cancel Brexit (a ludicrous thought that only highlights the gulf in understanding between the UK and the Continent), it is only now – after being convinced of the likelihood of collateral damage in its own country – that Germany is taking a more conciliatory approach. An extension of Article 50 is likely to give enough time to conclude a deal. I see a second referendum as the least likely outcome, with a general election as more likely. Across the pond, it is hard to see a resolution to the US Government shutdown other than President Donald Trump declaring an emergency that would let him reallocate funds that Congress has appropriated for military construction in order to build his wall. Of course, the Democrats will sue him, but at least the government would re-open and both sides could declare victory. US-China trade negotiations are entering a crucial stage and the likelihood of a Deal seems quite high. It is clear that trade wars are not easy to win and Trump is ready to fold, declare victory and focus on getting re-elected. He wouldn’t want China tariffs to be part of the 2020 campaign. China, on the other hand, would be relieved. Meanwhile in Europe, Germany is on the brink of a recession, as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. The Eurozone is in a precarious position. Germany ought to embark on deficit spending and flex the rigid “growth and stability” pact to get the whole Eurozone out of its slow decline. Will they? Don’t hold your breath.
Deal, No Deal or Second referendum?
Last week, Annegret Kramp-Karrenbauer the head of the ruling Christian Democratic Union (CDU) party in Germany and the likely next Chancellor, as well as over two dozen other German luminaries from the fields of politics, art, industry and sport issued a plea to the UK to change its mind and stay in the European Union (EU). The letter published in The Times of London marks a significant shift in Berlin’s tone. It talks about the role of Britain – “we realise that the freedom we enjoy as Europeans today has in many ways been built and defended by the British people” and its continued importance to Europe’s future – “Without your great nation, this continent would not be what it is today: a community defined by freedom and prosperity.” And goes on to implore –“We would miss Britain as part of the European Union, especially in these troubled times. Therefore, Britons should know: from the bottom of our hearts, we want them to stay.”
A bit too late in the day, I’d say. Where were these good people before the referendum in 2016? That was the time for the esteemed leaders of the EU to give then UK Prime Minister David Cameron a worthy deal that he could sell to the British people. Instead, they gave him a bag of crisp hot Brussels air which Cameron tried to present to the British voters as a “great win,” and was repudiated.
The realisation is dawning on many in the EU that a No Deal Brexit would hit the EU very hard and is therefore an undesirable outcome. After hoping and wrongly presuming that the UK would cancel Brexit (a ludicrous thought that only highlights the gulf in understanding between the UK and the Continent), it is only now – after being convinced of the likelihood of collateral damage in its own country – that Germany is taking a more conciliatory approach.
Anyone with any interest in Germany and the EU and where they’re headed, would be well served to read the masterful analysis of the topic in the book Berlin Rules: Europe and the German Way. It is written by Sir Paul Lever, former British Ambassador to Germany and a senior member of the European Commission in Brussels who attended all European Council meetings from February 1979-85. In its institutional form, he suggests that the EU looks and “will continue to look like Germany” and that its “leadership of the EU is geared principally to the defence of German national interests.” His conclusion is that Germany will prevent the creation of the “all-powerful European super-state that ” and in 20 years’ time many (Brits) will have forgotten Britain was ever a member of the EU to make them regret their choice” and “others… may wonder what all the fuss was about.” I recommend the book highly.
Last week also saw UK Prime Minister Theresa May suffer the largest parliamentary defeat in British political history, as the House of Commons rejected her Deal on Europe by 432 to 202 votes. By any yardstick, the defeat that May suffered is entirely of her own making. Tin-eared, distant, and reticent don’t even begin to define the approach she took to agreeing a “Withdrawal Agreement” with an intransigent EU. May couldn’t persuade a starving man to eat with the approach she has taken thus far. Tories must fear a terrible drubbing at the elections, if May continues as PM. Thankfully, she has promised she won’t lead the Tories into the next election.
So, what’s next?
To those who say “No Deal” is off the table or Brexit could be cancelled, I say this – No deal is not “on the table” but it is in the Statute Books. The European Union (Withdrawal) Act 2018 was passed through both Houses of Parliament and became law by Royal Assent on 26 June 2018. 498 of 650 MPs voted to trigger Article 50 i.e. a clear and overwhelming commitment to leave the EU. Over 80% of MPs subsequently were re-elected in 2017 on manifestos pledging to implement Brexit. Legally, in the absence of an agreed deal, the UK, therefore, will leave with “No Deal” on March 29, unless the Article 50 deadline is extended by the mutual agreement of the EU and the UK. A No Deal, however, doesn’t mean “crashing out” as some like to fear monger. It just means agreeing a set of side deals and a temporary return to WTO rules for trading, until new trade deals and arrangements are worked out between both parties.
As I said on Bloomberg TV last week- I still believe that the UK will leave the EU with a deal. An extension of Article 50 is likely to give enough time to conclude a deal. There will be a transition period in which the UK will be part of the customs union and at the end of the transition period, the EU and the UK will move on to a Free Trade Agreement (FTA). As far as the UK is concerned the “freedom of movement” of workers is a red line and will not be up for negotiation.
The EU doesn’t want a No Deal scenario. Nor does the UK for that matter. A No Deal would be very inconvenient for the UK in the short term, as details of new arrangements are worked out, but it would be a growing tragedy for the EU to lose a nation it has a big trade deficit with. Besides a No Deal at, minimum, means:
• Immediate halt to the £39 billion “divorce payment” to the EU
• No further annual contributions of £13 billion to the EU budget
• The EU’s entire exports to the UK – £341 billion last year would be put at risk
• A severe macroeconomic calamity for Ireland
This, at a time when the economic woes of Germany (the driver of the EU 27) are growing as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. A German slowdown is already ringing alarm bells in Brussels and at the European Central Bank (ECB).
Weaker German growth is very bad news for the rest of the European continent, where many economies are linked to the demands of the German export machine and German consumers. For instance, Germany is France and Italy’s top export destination with 15% of total French exports and 12.5% of total Italian exports going to Germany. A slowdown in Germany would hit France and Italy hard. The possibility of a No Deal or messy Brexit, populism and unrest in France, mounting US protectionism and the slowdown in China all are major headwinds for Germany and the Eurozone. China is Germany’s largest trading partner ahead of the US. If that’s not enough, cast your mind back to last July and the Trump-Juncker conference that temporarily diffused the risk of damaging tariffs on EU auto exports to the US, in return for the EU pledging to work to achieve “zero tariffs, zero non-tariff barriers, and zero subsidies on non-auto industrial goods.”
Fast forward 6 months, and the EU is now being accused by US officials of dragging its feet on trade talks in the hopes of waiting out the Trump administration. It won’t end well if you know what Trump is like. President Donald Trump is about to conclude a trade deal with China. With the Mexico-Canada and China deals completed, all efforts and urgency will go into taking on what Trump likes to call the EU’s “unfair trade deal” with the US that “robs” the US and treats it like a “piggy bank”. Expect fireworks soon.
I see a second referendum as the least likely outcome. A general election is more likely than a second referendum. We know that the country is divided roughly down the middle – half favouring Leave and half favouring Remain. A new referendum will only frustrate those who voted to leave and waste valuable time and resources. Even if there were a second referendum, in my opinion, Leave is likely to win again. In a tweet, Robbie Gibb, Director of Communication at 10 Downing Street reminded us as much – “1.9 million Leave voters say they would now vote to Remain. But 2.4 million Remain voters would now vote to Leave. The country hasn’t changed its mind.” Remember also that the voters were told the Brexit referendum was a “once in a lifetime vote” and 3 years is not a lifetime by any stretch of the imagination. For many in the UK – whether Remainer or Brexiteer, a second vote amounts to a violation of democracy.
As for GBP/USD, the UK economic data on a relative basis is getting better and the US is unlikely to raise rates until the summer given concern about the economic slowdown in the US. Therefore I see GBP/USD getting to 1.32 by June, creeping up to 1.36 or higher by September and 1.40 or higher next year.
Economy & Markets
The US Government shutdown that started before Christmas carries on and is now the longest government shutdown in US history – beating the 21-day clash between President Bill Clinton and the Republican Congress over federal spending that stretched from December 16, 1995, to January 5, 1996. The shutdown is now entering its fifth week and shows no signs of coming to an end. Trump is adamant on getting the $5.7 billion funding he needs to fulfil the campaign pledge to build a wall on the US-Mexico border. Democrats on the other side buoyed by their successes in the mid-term elections, are refusing to grant Trump that money. Democrats insist – reopen the government first, talk later. Trump insists – fund the wall first, reopen the government thereafter. The deadlock continues.
In a televised speech over the weekend, Trump made an important concession – calling for $5.7 billion in funding for the wall in exchange for a three-year protection from deportation for young immigrants illegally brought to the US as children, known as Dreamers. US Senator Chuck Schumer and House Speaker Nancy Pelosi rejected this outright with Pelosi calling it a “non-starter.” Schumer shut down the government in January 2018 for 3 days because protection for Dreamers was not in the budget for 2018. Now he’s refusing to co-operate and open the Government, when the protection for Dreamers is included in this latest offer from Trump. It’s hard to see a resolution other than Trump declaring an emergency that would let him reallocate funds that Congress has appropriated for military construction to build his wall. Of course, the Democrats would sue him, but at least the government would re-open and both sides could declare victory.
Meanwhile, the US government may be shut down, but the markets are off to the races. The table below indicates the stellar run so far in 2019, albeit given the sell-off in December, the rally is still only a comeback or a recovery rally.
While Energy (XLE) leads all sectors at +11.3% on the back of crude oil’s +24% surge, Brazil (IBOV) leads all countries in the matrix above with a YTD gain of +11.2%. Remember Energy was the worst performing sector last year down -20.6%.
The Q4 earnings reporting period got underway last week in the US. This season couldn’t have started more differently than the last, when investors were selling anything and everything, and it culminated in the S&P 500 index falling off a cliff in December. Less than 100 stocks have reported so far, so there’s still a long way to go. Of those, 69% have beaten consensus analyst estimates (a strong reading) but only 49% have beaten top-line consensus revenue estimates (a weak reading). The revenue beat has been falling for the last four quarters and points to a slowdown in the economy – which is not a bad thing overall, as it will keep the US Federal Reserve (Fed) from raising rates anytime soon.
Recall, the Fed last month raised its benchmark Fed Fund Rate (FFR) by +0.25% to a range between +2.25% and +2.50% and indicated it could raise rates twice this year. At the press conference that followed, Fed Chairman Jerome Powell struck, what the market thought, was a hawkish tone and risk assets promptly sold-off. The sell-off just kept getting worse into the holiday period. Since then, Powell and his colleagues at the Fed have spoken at various forums to allay the worries that the Fed is on a pre-set path. “There is no pre-set path for rates,” Powell said during an appearance at the Economic Club of Washington, D.C. ten days ago. He added – “We’ll take into account tightening financial conditions, which we’ve seen, and we’ll also lower our rate path and try to have monetary policy offset weakness before it even happens.” I do not see a US rate hike until June at least.
US-China trade negotiations are entering a crucial stage and, in recent days, Trump has made positive remarks on the prospects of striking a deal. “I think we’re going to be able to do a deal with China” he tweeted last week. The U.S. and China are seeking to resolve their dispute ahead of a March 1 deadline, when in case of no deal, the tariffs on $200 billion of Chinese goods are scheduled to jump to 25% from the current 10%. In a very positive, and rather surprising turn of events, The Wall Street Journal reported last week that US officials are debating ratcheting back tariffs on Chinese imports, as a way to calm markets and give Beijing an incentive to make deeper concessions in a trade battle that has rattled global economies. This seems a striking turnaround for an administration that hasn’t lifted steel and aluminium tariffs on its closest allies and is still threatening them with a 25% levy on car imports. Treasury Secretary Steven Mnuchin has talked of eliminating the tariffs on $200 billion of Chinese goods and raised the possibility of lifting tariffs on an additional $50 billion of Chinese goods that have been in effect since August. However, Mnuchin faces resistance from US Trade Representative Robert Lighthizer, who is concerned that any concession could be seen as a sign of weakness. In the past, Trump has sided with Lighthizer on tariffs, rather than Mnuchin. But this time, he has made it clear he wants a deal—and is pressing Lighthizer to deliver one, according to people familiar with the discussions. So it seems trade wars are not easy to win and Trump is ready to fold, declare victory and focus on getting re-elected. He wouldn’t want China tariffs to be part of the 2020 campaign. China, on the other hand, would be relieved and of course trade fairly with the rest of the world as soon as it starts exporting of high-quality products – telecom products an example, and Chinese companies start outsourcing cheap labour to other countries. This is pretty much what happened with Japan decades ago, as it went from making “knock-off” products in the 1960 and 70s to innovative new products in the 80s and the 90s and became a world leader in manufacturing.
Meanwhile in Europe, as mentioned above, Germany is on the brink of a recession as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. Germany’s economy shrank in the third quarter of 2018 for the first time since 2015. Germany is one of only a few Western economies to have had huge success exporting to China. It is not only German car manufacturers that are impacted, but some 5,200 German companies operate in China, many of them midsize engineering firms that deliver the capital goods that China has used to power its factories and build its infrastructure. The Eurozone is in a precarious position. Germany ought to embark on deficit spending and flex the rigid “growth and stability” pact to get the whole Eurozone out of its slow decline. Will they? Don’t hold your breath.
So in light of all of the above, my allocation still remains overweight to US equities. I also feel very positive about Emerging Markets (EEM US) and particularly the China tech stocks (Alibaba, Baidu, Tencent, JD.com) and stocks with China exposure (Micron Technology, Apple etc.). As for US sectors, I stay overweight US Financials (XLF), US Communication Services (XLC) and US Healthcare (XLV)
Finally just to remind you about what I wrote in the November Market Viewpoints. Since 1946, there have been 18 midterm elections and US stocks were higher 12 months after every single one. Yes, every single one. That’s 18 for 18. Since 1946, stocks have risen an average of +17% in the year after a midterm election. We’re also in the third year of a presidential term, which is historically the strongest year for stocks. You will note that the performance of stocks in the third year of a presidential term beats all other years by a long shot. Therefore, I recommend you stay long equities.
Other stocks I like: In terms of stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US), Lam Research (LRCX US), VINCI (DG FP).
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
The slowdown in the housing sector, stresses in the leveraged loan market, and low oil prices are all pointing to a more “dovish” hike in interest rates by the US Federal Reserve on Wednesday. A part of me is tempted to say that assuming the Fed raises rates as expected, it is likely to be the last of this economic cycle. But then again, I look at the historically low level of unemployment and also believe that a deal between China and the US will be struck in time, and I am led to conclude that the Fed will still be able to raise interest rates next year. As for the politics of populism, Europe will be the hotbed in 2019. The slowdown in growth in the Eurozone – Q3 GDP growth down to +0.2% (December 2013 level) – doesn’t help one bit in dealing with it. The Gilets Jaunes has already humiliated French President Emmanuel Macron and forced him into an embarrassing climb down that will put a great strain on the French economy. I doubt Macron will recover from this debacle. I expect equities will rise post the Fed meeting this week as the dovish views finally get priced in. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off. The US economy does not need a tax cut. In fact, a tax cut will be counterproductive and it may overheat the economy, get the Fed to step in and raise rates and cause a recession in 2019.
Red cups at Starbucks, a festive range of bags at Marks and Spencer, special window displays on the lit-up and decorated high street – can only mean one thing – Christmas is coming. However, for me, what really signals the arrival of the holidays is the arrival of The Nutcracker. This family-friendly ballet set to Pyotr Ilyich Tchaikovsky’s famous notes “The Nutcracker” originated in Russia. It made its debut at the Marinsky Theatre in St. Petersburg in 1892, a year before Tchaikovsky’s death and is based on “Nutcracker and the Mouse King,” an 1816 story by German author E.T.A. Hoffmann which tells the story of a little girl Clara, her toy nutcracker and their adventure in a kingdom of sweets at Christmas time. The original version was panned by critics and wasn’t performed outside Russia in its entirety until 1934 when Nicholas Sergeyev staged it at the Sadler’s Wells Theatre in London. In the US, The Nutcracker didn’t become popular until 1954 when George Balanchine’s (a Russian-American ballet dancer turned choreographer) production for the New York City Ballet – complete with a Christmas tree rising out of the stage – hit the mark with the audience and an American tradition of watching the ballet at Christmas was born. This ballet has everything – fantasy, love, spectacle and the music is brilliant and familiar because it is out of copyright and therefore has featured in countless advertisements. Some reports suggest that this one ballet accounts for 40-50% of the annual revenues for professional ballet companies.
Source: Moscow Ballet (www.nutcracker.com)
Whilst The Nutcracker is a festive treat, what theatregoers don’t realise is that they are watching an important period of history. Russians living in St. Petersburg who saw the ballet for the first time were part of a generation experiencing a level of prosperity never seen before in history. The Industrial revolution had brought rich dividends to Europe and the US, and Russia was very much considered a part of Europe then. The middle class lived in secure and comfortable homes with amenities such indoor plumbing, an electric stove, radio, television, and even hair dryers! It was a time of innovation and prosperity in Europe and the US. The decade that was the 1890s brought forth so many ideas and inventions that the Commissioner of the US Patent Office at the time, Charles Duell said in 1899 -“Everything that can be invented has been invented.” We see hints of prosperity in the opening scene of the ballet – it’s Christmas Eve and Clara and her extended family are hosting a huge Christmas party with an abundance of food, drink and gifts. It symbolises a world that loved globalism and trade. In the ballet, you see foreign delicacies – Spanish hot chocolate, Chinese tea, Arabian coffee and the famed sugar plum fairies, Danish shepherdesses, and of course Russian candy cane dancers along with a beautiful array of fantasy figures. Little did the people then know what was to soon to follow in Russia and in Europe. The happiness, merriment and times of plenty would soon give way to the darker sides of humanity – revolution and war – which would adversely impact the lives of millions.
With populism, protectionism and revolution again in the ascendency, are we in for similar times ahead?
The year 2018 will go down as one of the best in the nine recent years of US economic expansion. The unemployment rate, at +3.7%, remains at a 49-year low. US GDP rose by +3% in Q3 from a year earlier, a rate of growth exceeded in only three other quarters in this expansion that began in March 2009. Inflation reached the US Federal Reserve’s (Fed) target of +2% without overshooting it and wage growth is inching up to +3% (still well below the +4% of past expansions). Meanwhile, in the rest of the world, the year began with most major economies expanding – leading some to think that Europe was going to expand at an even faster rate than the year before. Regular readers of this newsletter will know that – because of its structural problems – I take a very dim view on the Eurozone economy. By the third quarter, output in Germany – the Eurozone’s largest economy – had contracted and the Eurozone is expected to grow at sub +1% rate this year. Japan has also seen a slowdown and as China’s economy and global trade volumes slowed, many Central Banks globally took a step back from sounding hawkish on interest rates.
As the table below shows, this year, the US is a stand out performer in an otherwise miserable sea of red in the world of equities.
And to think that everything was going well for US equities – despite the sharp -11% correction in February. The S&P 500 Index (SPX) was up over +9% until early in October, before the narrative of a US-China trade war, Fed interest rate increases, a turn in the economic cycle and a strong US Dollar took a stranglehold on equities. This all resulted in a sharp -14% market sell-off since then (see chart below). Traders and speculators out-manoeuvred investors and it’s been a volatile market ever since.
Markets & Economy
The Fed will conclude its final meeting of the year this Wednesday with markets widely expecting the Fed to raise rates by +0.25%. This will take the Fed Funds Rate to the +2.25% to +2.5% range. However, the slowdown in the housing sector, stresses in the leveraged loan market, and low oil prices are all pointing to a more “dovish” hike on Wednesday. A part of me is tempted to say that assuming the Fed raises rates as expected this week, it is likely to be the last of this economic cycle. But then again, I look at the historically low level of unemployment and also believe that a deal between China and the US will be struck in time, and I am led to conclude that the Fed will be still be able to raise interest rates next year. As per the Fed Funds futures pricing, the most-likely scenario (at a 40% probability) is no change in the Fed Fund Rate for the entire 2019. The likelihood of one rate increase sits at 33% and two hikes at 12%. At the extremes – a rate cut stands at 10.6% and the odds of a repeat of 2018 with more than two hikes is a meagre 2.4%.
In the November 2017 Market Viewpoints, I forecast that the 10 Year yield on US Treasurys would “finish the year in the range +2.85% and +3.0%” and we are at +2.86% currently. For the next year, I forecast that we are going to see, at most, two rate hikes from the Fed and the 10y yield on US Treasurys will finish the year in +3.25% to +3.4% range.
As for the politics of populism, Europe will be the hotbed in 2019. The slowdown in growth in the Eurozone – Q3 GDP growth down to +0.2% (December 2013 level) – doesn’t help one bit in dealing with it. The Gilets Jaunes have already humiliated French President Emmanuel Macron and forced him into an embarrassing climb down that will put a great strain on the French economy. The Bank of France has halved its forecast for France’s GDP growth in Q4 from +0.4% to +0.2% and the deficit is to balloon to -3.4% of GDP (well above the 3% ceiling that the Eurozone nations have to abide by).
Recall that Italy’s 2019 planned deficit, which is set to be -2.4%, has been a problem within the EU.
The next recession will tip France over and make its budget a concern for Brussels and a big headache for Germany and the European Central Bank (ECB). I doubt Macron will recover from this debacle. He has lost the trust and confidence of the French people and will have a very hard time to govern going forward.
The French middle class are sick of taxes. The chart below sums up why The Gilets Jaunes have garnered overwhelming support. Hours before the government cancelled its proposed tax rise, a poll conducted for French newspaper Le Figaro showed 78% believed the yellow vests are fighting for France’s general interest.
The Organization for Economic Cooperation and Development (OECD) released its annual Revenue Statistics report last week and France topped the charts, with a tax take equal to 46.2% of GDP in 2017. That’s more than Denmark (46%), Sweden (44%) and Germany (37.5%), and far more than the OECD average (34.2%) or the U.S. (27.1%, which includes all levels of government). Macron’s France shows that states can’t support themselves solely with progressive income taxes. More taxes are equal to less progress. France has resisted supply-side reforms for decades and engendered a socialist economy with a few wealth creators paying for the many takers. Now the chickens have come home to roost. Belgium and Netherlands are now seeing their own version of Gilets Jaunes protests.
I expect equities will rise post the Fed meeting this week as the dovish views finally get priced in. Since the close on November 8 (the last meeting), the SPX is down over -9%. That’s the biggest decline in between Fed Days since the -8.17% drop between the December 2015 and January 2016 meetings. Recall, that the current hiking cycle began at the December 2015 meeting which sparked a -10% sell-off.
I still recommend an overweight position in equities with a bias to US equities and sectoral bias to – Industrials (XLI), Technology (XLK), Financials (XLF) and Healthcare (XLV). Despite the news of a yield curve inversion at the front end (2 year and 5 year), I put the probability of a recession in the US next year at very low. The US economy is set to grow at over +2% rate in 2019. This leaves a window for equities and other risk assets to show renewed strength given the recent sell-off. The US economy does not need a tax cut. In fact, a tax cut will be counterproductive and it may overheat the economy, get the Fed to step in and raise rates and cause a recession in 2019.
The risk of GDP growth is more daunting outside the US and any further tilts to protectionism and nationalism will make matters worse. The backdrop for Emerging Markets (EM) is certainly better given the de-rating relative to the US equities (chart below) and the anticipated reduction in the pace of rate hikes from the Fed. Besides a combination of continued US growth and a modest upturn in the Chinese economy would alleviate many concerns. The result could be a meaningful rally in pro-cyclical EM assets – bonds and equities.
I was bullish on floating rate bonds through last year but I do not feel the same now for the reasons mentioned above – fewer rate hikes. I would recommend reducing the weight of floating rates bonds in the portfolio gradually. The yield on fixed-rate bonds is getting attractive enough to hold them outright.
As for currencies, traders are already very long US Dollar, implying the upside to USD is limited. However, for the USD to weaken, global growth has to improve. The interest differential still supports the US Dollar. I do not expect any meaningful upturn in the Chinese economy until late Q2 of 2019. As Chinese economic activity weakens, European growth will sputter. Therefore, I expect the EUR/ USD to trade below 1.10 in the first half of 2019.
On that note, I wish you and your family all the best for this holiday season as well as a very Happy New Year. And if you celebrate Christmas – have a lovely Christmas!
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
The “political declaration” that Prime Minister Theresa May has agreed with the European Union (EU) is very vague and has very few details about what the future relationship between the EU and the UK will be. The declaration doesn’t commit the EU to anything. It’s not a legal agreement, unlike the 525-page “Withdrawal agreement”‘ which includes guarantees that are legally binding including the £39 billion “divorce bill” the UK will pay the EU, albeit over several years. Besides, the biggest bone of contention in the agreement – the Irish backstop – still remains. I do not see it passing the UK Parliament in its current form and even if it does, I strongly believe the Tory party will split and a new election will see Labour come to power. There is many a Conservative party voter who would not vote for the Conservative party again, such is the level of opposition to May’s “Withdrawal agreement.” Now, of course, all this could be averted if the deal were amended and the Irish backstop is either removed or has a fixed period of validity. I expect US economic growth to slow down next year and therefore believe that the US Federal Reserve (Fed) will pause hiking interest rates. I expect the Fed to increase rates only twice next year. The G-20 summit will be held at the end of this month in Argentina. With US President Donald Trump pushing publicly for a trade deal with China and China loosening its Joint Venture requirements ahead of the meeting, signs are that both sides want to make progress on this issue at the summit. We could see a rally in risk assets if a deal comes to pass or even if the 25% tariffs that are to come into effect in January are postponed. By the end of Q2, the US would have entered the 2020 Presidential election cycle and Trump will do all he can to get re-elected. For that, he needs a healthy economy, a high reading on the S&P 500 Index, low unemployment, rising wages and oh yes, no recession.
No Revolution Please, We’re British
Last Thursday was a day of feverish political frenzy in the UK. At one point it looked like the number of ministerial resignations could easily run into the double digits as displeasure within the Cabinet and the Conservative party grew with the Withdrawal Deal Prime Minister Theresa May had agreed with the European Union’s (EU) chief Brexit Negotiator Michel Barnier. Two cabinet resignations promptly followed including that of the Brexit Minister, Dominic Raab and rumours swirled that May could be pushed out in a vote of no confidence. As we waited for May to speak from the steps of Downing Street one of my staunchly Francophile colleagues remarked- “I really admire the English. They may be unhappy with Theresa May and her Brexit withdrawal deal but they don’t go out on the street and strike or carry out a revolution”. He was obviously drawing a comparison to strikes and protest, which are an essential part of life in France.
So why don’t the English revolt? Why in hundreds of years has there not been similar upheavals to the revolutions and civil wars in say, France or Russia?
The short answer is there have been revolutions in Britain – the Peasants’ Revolt of (1381), the Glorious Revolution (1688-89), the Jacobite rising (1715-1716) and others. The reason they are not remembered as well as the French Revolution or the Russian Revolution is that they were all unsuccessful. The rebels have only one success to show – the English Civil War of (1642- 1651) when King Charles I was defeated by Oliver Cromwell’s army and eventually executed. The English tried the new system – England as a Republic – for a decade, decided it didn’t work and in 1660 promptly reverted to the monarchy (albeit a constitutional monarchy with parliamentary controls) crowning Charles II (Son of Charles I) as King of England, Scotland and Ireland.
The long and considered answer is that for hundreds of years, Britain has been a more democratic nation, with a rich parliamentary history of reforms, when compared to other European nations and has granted more rights to its people sooner. The English had rights and property ownership going back over 800 years. The Magna Carta and the Doomsday Book are fine examples. The latter,a record of a huge survey of land and landholding commissioned in 1085, and the former, a charter of rights agreed to by King John of England at Runnymede, near Windsor, on 15 June 1215 that served as the foundation of the freedom of the individual against the arbitrary authority of the monarch/state. The Magna Carta became a major influence on the Constitution of the United States of America and the Bill of Rights, and the Constitutions of several other countries. Therefore, while the rest of Europe had to resort to political revolutions to win rights, the English didn’t have the same urge, or need, as the State reformed far more willingly (albeit under social pressure) and regularly.
As former US President John F. Kennedy said, “Those who make peaceful revolution impossible will make violent revolution inevitable.” Britain made “peaceful revolutions” and follow up reforms possible. The 1832 Reform Act gave a vote to the middle class. Its successor, the 1867 Reform Act gave a vote to every male adult householder living in towns. The Suffragettes movement in 1914 led to women getting voting rights. The social reforms in 1906-1914 brought in – Medical tests for pupils at schools and free treatment provided, compensation to workers for injuries at work, the introduction of a pension of five shillings for those over 70 that freed the pensioners from fear of the workhouse. In 1911, the government introduced the National Insurance Act that provided insurance for workers in a time of sickness and unemployment. And when the House of Lords resisted some of these reforms, an Act of Parliament in 1909 ended the veto of the House of Lords. Britain’s government was the model most Liberals throughout Europe sought to copy. The would-be rebels in Britain, therefore, have always had just enough “equity” to keep them from rebelling and burning down the establishment.
Source: Oxford University Press
The revolution that England is most remembered for is the Industrial Revolution and it spread to mainland Europe, including France. Further, a democratic vote in Britain is not one that is ignored or redone but implemented in toto and I have no doubt that the Brexit vote (unlike previous referendums on the membership of the EU in other parts of Europe) will be implemented in full.
On Thursday this week, May and Brussels signed off on a much-anticipated 26-page “political declaration” document that outlined the future relationship that the EU and the UK are committed to forging. A partnership that is “ambitious, broad, deep and flexible.” Just warm fuzzy words? We shall see. Agreement of the text paves the way for a special summit on Sunday at which May and the EU27 leaders will formally agree both the withdrawal agreement and the political declaration. May addressed the House of Commons in an emergency statement in which she reiterated that there would not be a second referendum as long as she was Prime Minister.
So what happens next?
The “political declaration” is very vague and has very few details about what the future relationship between the EU and the UK will be. The declaration doesn’t commit the EU to anything. It’s not a legal agreement, unlike the “Withdrawal deal” which includes guarantees that are legally binding including the £39 billion “divorce bill” the UK will pay the EU albeit over several years. Besides, the biggest bone of contention in the withdrawal deal – the Irish backstop – still remains. If, by the end of the transition period on 31 December 2020 a new trade deal between the EU and the UK is not agreed, then the Irish backstop would automatically kick in and Northern Ireland (or indeed the whole of the UK) would continue to remain part of the EU single market and customs union – i.e. UK will not be able to sign new trade deals with the rest of the world and will become a rule taker with no influence on future EU rules and regulations. Besides, once activated the backstop can only be revoked by the joint agreement of the UK and the EU. No party can individually call time on the backstop. The Brexiteers interpret this as a ploy by the EU to keep the UK in the single market and customs union for the long-term (if not forever) and deny the UK the Brexit it voted for.
I do not see the Withdrawal Bill in its current form with the Irish backstop passing through the UK Parliament and if it does, I strongly believe the Tory party will split and a new election will see Labour come to power. There is many a Conservative party voter who would not vote for the Conservative party again, such is the level of opposition to May’s Withdrawal Bill. Now, of course, all this could be averted if the deal were amended and the Irish backstop is either removed or has a fixed period of validity i.e. it pushes the EU and the UK to conclude a deal in an agreed time frame so that there is no need for a backstop to be activated. I do believe the deal will be amended. An addendum will likely appear that allays the backstop concerns when the bill is signed this weekend. Or it may not and when the bill is voted down in the UK Parliament in early December, the need for that addendum will become more urgent to avoid a No Deal Brexit. In any case, I still stick to my base case scenario that the willingness to avoid a No Deal scenario come March 29, 2019, is very high on both the UK and the EU 27 side. Therefore a solution will be worked out and the UK will leave the EU on March 29 next year and enter a transition period that will last at least until December 31, 2020.
The EU has major challenges ahead and its leaders are losing popular support. German Chancellor Angela Merkel is on her way out and French President Emmanuel Macron’s approval rating has dropped to 25% (the French hate almost all their Presidents. Francois Hollande had a 4% approval rating at one point in 2016). The Italian budget crisis and indeed Italian debt threaten the stability of the EU and the Euro and Greece is lining up for another bailout. Add to this the EU army, which I believe, will be busier averting/fighting internal battles than meeting external foes. The only countries still desperate enough to want to get in the EU are Ukraine and Scotland. In the case of Scotland, it hasn’t dawned on their leader Nicola Sturgeon that with over -8% budget deficit, Scotland is nearly three times over the budget deficit target needed to join the EU. If Scotland were to leave the UK, the savings to the UK in transfer payments to Scotland will be far higher than anything promised on the side of the red bus by the Brexiteers. If Nicola Sturgeon wants independence she should let the English vote in the next Scottish referendum.
Markets & Economy
For the fifth time this year, the S&P 500 Index (SPX) is down by more than -5% from peak-to-trough with two drops of greater than -10% recorded in January and October. Contrast this to last year when we didn’t have a single drop of more than -3% and the year finished with a gain of +20% for the index. Much of the move this year is attributed to – a maturing economic cycle, tariff uncertainty primary (but not limited) to a US-China trade war and the US Federal Reserve (Fed) in a tightening mode. Despite the market volatility, all through the year, the Fed is still set to hike 4 times in 2018 with the last hike likely to come at its December meeting. If that were the only tightening, we’d probably be fine. However, as markets are interlinked, the US Dollar has also strengthened and further tightened the financial conditions for Emerging Markets causing them to slow down. The big difference in the performance of equity markets in local currency versus in US Dollar terms highlights this currency effect (see table below). To add to this, the Fed balance sheet drain is also proceeding at a gradual pace i.e. another tightening move to add to the two above – rising rates and a strong US Dollar.
I do expect the US growth to slow down next year and therefore believe that the Fed will pause hiking interest rates. I expect the Fed to increase rates only twice next year. Having said that, I do not see a US recession on the horizon. The US economic cycle has further to run and US consumers, in particular, remain strong. The sell-off, therefore, represents a buying opportunity for global stocks. Brexit, political risks in Italy, trade tensions and a potential slowdown in China could overhang longer but don’t forget ultimately a resolution of the issues is in the mutual interest of the parties involved. No wonder European Central Bank (ECB) President Mario Draghi says there will be a deal between Italy and the EU to resolve the budget crisis and Trump is publicly signalling a détente with China.
The G-20 summit will be held at the end of this month in Argentina. In 2016, we saw a similar tightening of financial conditions with the concerns that the Fed was being too tight too soon. As a result, USD was strengthening, CNY was weakening and Oil was getting battered. The G20 summit then in Hangzhou led to a “Hangzhou pact” as policymakers decided that tightening financial conditions was not an optimal policy. Are we seeing a similar setup today? With Trump pushing publicly for a trade deal with China, the Fed starting to show some wiggle room, and China loosening its JV requirements ahead of the G-20 meeting, we could see a rally in risk assets if a deal comes to pass or even if the 25% tariffs that are to come into effect in January are postponed. Peter Navarro, the controversial White House trade policy adviser and a famous China hawk, has been excluded from the Xi Jinping-Donald Trump dinner at the G-20 in Buenos Aires on December 1. Exclusion of a famous China hawk and a key figure behind the US-China trade war indicates that both sides want to make progress on the dispute at the summit. I do see a comprehensive US-China trade deal being signed by the end of Q1/early Q2. One has to just remember – America has elections, China does not. By the end of Q2, the US would have entered the 2020 Presidential election cycle and Trump will do all he can to get re-elected. For that, he needs a healthy economy, a high reading on SPX, low unemployment, rising wages and oh yes, no recession.
In investing, a keen eye for history is always very helpful. So if you are frustrated by the volatility this year and want to sell everything and go into cash as you believe a recession is down the corner in the US, then the next three paragraphs are particularly useful for you. I suggest you read them carefully and take note of the statistics.
It’s correct that this US recovery, which started in Q2 2009, has gone on for a long time but that is no reason for it to end and a recession to set in. Australia hasn’t had a recession in 27 years and as we all know Australia is very much on planet earth just as the rest of the world and trades with earthlings and not Martians.
Here are few key stats that I came across while reading a RiskHedge report on the MarketWatch website.
In the chart above you’ll also notice the second year of the presidential cycle is typically the worst for stocks. That’s the year we’re in right now — the year when midterms occur. The SPX was as high as +9% in October and is now flat. We still have 5 weeks until the end of the year. A run to 2800 (very possible) could still make it a +4% year for the SPX.
With Germany experiencing negative GDP growth in Q3 this year, things are not looking well for the European growth story. A US-China deal, of course, would help. It seems Greece is in need of another bailout, something I predicted in the August newsletter. I wrote then – “Only in the EU could a bailout be described as ended by completely ignoring the over €330 billion that has to be repaid by 10 million people who don’t like paying taxes. Besides the taxes and regulatory burdens put on Greece as part of the bailout program have made growth unstainable and economic prospects still remain grim. The charade of interest payment deferrals and extending the maturity of the debt can only go so far. So give it a few months and Greece will be back in the news seeking a fresh bailout. Greece is like Groundhog Day but without the happy ending.” In retrospect, those words are quite prescient now. I am not bullish on Eurozone growth and don’t see how the ECB will be able to end its quantitative easing (QE) policy this year in face of a growth slowdown and negative growth in EU’s largest economy. I still prefer to be overweight the US economy and the US Dollar and find Emerging Market (EM) equities very attractive. Low oil prices are a boost to many including India, Korea, China and indeed US consumers.
Chinese equities (ASHR) are making an attempt to bottom. The recent lows have held so far and are right near the bear market low that was made back in early 2016. The ASHR ETF has recently made two “higher lows” (chart above), a classic bullish turning point. If the Fed policy turns more dovish and/or Trump starts to soften on trade, ASHR should see very good gains.
I believe the concerns about Apple (APPL) are overdone. Apple is not at the limit of its price premium for the iPhone. It’s true when pricing power is lost; consumer technology companies tend to either lose margins or market share or both. Apple phones are still a premium product and vast sections of consumers in the EM are yet to join the mobile phone world and get connected. I have added to Apple (APPL), Google (GOOG), Amazon (AMZN), Alibaba (BABA), Micron Technology (MU) and other tech positions to our portfolios.
I continue to be long US equities, with sector preferences for Technology (XLK), Financials (XLF), Healthcare (XLV) and Industrials (XLI). I also recommend an increased allocation to Emerging Markets Equities.
In terms of stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US).
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
Big electoral losses in the State legislature elections in the second and the fifth most populous states in Germany – Bavaria and Hessen – have dealt further blows to German Chancellor Angela Merkel and her ruling coalition. The move to the right (and in some cases far right) in recent elections in the US, UK, Germany, Austria, Netherlands, Italy, Sweden, Poland, Hungary and so on, indicates that, in the Western economies at least, the leftist parties have become rigid ideologues that no longer truly represent their people. Voters are therefore abandoning them and are willing to try new and untested political parties and personalities. This polarization is set to continue and, in Europe, the full effect of it will be felt in the upcoming European elections in May when the “populists” from across Europe take their seats in the European Parliament in Brussels in increased numbers. I believe Merkel is on borrowed time. Giving up the Chair of her party will increase the pressure on her to resign as Chancellor before her term ends in 2021. The Presidential election in Brazil, Latin America’s biggest economy and the world’s fifth most-populous country, brought another populist to power. Jair Bolsonaro is quite a controversial figure with polarizing views on many a topic. But the fact that Brazil still voted him in says how tired Brazilians are of the last 13 years of the Workers’ Party (PT) rule, during which time corruption, debt and the deficit soared and Brazil fell into its worst recession in more than a century. The last three Presidents of the country have all been implicated in scandals and bribery. There was a feeling that if the PT returned to power, it would pick up where it left off and eventually turn Brazil into another Venezuela. Bolsonaro has pledged to clean up politics, crack down on crime, end Brazil’s flirtation with socialism, privatize and deregulate, rein in deficits, and open up the economy. If he delivers on even half his manifesto, Brazil would be the winner.
Merkel: a lame duck Chancellor?
The unemployment rate in Germany is at a 40-year low. The trade surplus is at a record high and, last year, Germany, experienced its best GDP growth in a decade. Yet Germans seem unhappy with Chancellor Angela Merkel who has been Chancellor for the last 13 years. Ever since Merkel opened Germany’s borders to nearly two million refugees three summers ago, things have not been the same in Germany, either socially and politically. Germany’s political mainstream, dominated by the Christian Democratic Union (CDU) and the Social Democrats (SPD) has been on the retreat. Big electoral losses in the state legislature elections in the second and the fifth most populous states of Germany – Bavaria and Hessen – have dealt further blows to Merkel and her ruling coalition.
Earlier this month, the affluent Bavaria with a population of over 12.5 million and home to such companies as BMW, Siemens and Adidas, stunned the incumbent Christian Social Union (CSU) – sister party to Merkel’s CDU – when it lost its absolute majority, its worst result since 1950 (chart below). To pile on the misery, over the weekend, the State elections in Hessen – home to Germany’s financial industry- dealt another blow to the “grand coalition” parties – the CDU and the SPD with the CDU polling 27.9% and the SPD plunging to 19.8% (chart below). In the last election, in 2013, the CDU and the SPD scored 38.3% and 30.7% respectively. The far-right Alternative for Germany (AfD) which didn’t exist 10 years ago and became the largest opposition party in the German parliament in the general election last year, polled 13.1% to enter the Hessen state legislature for the first time. The AfD is now represented in all 16 of Germany’s regional assemblies and has built a solid base throughout Germany as it continues to gain traction with German voters.
More worryingly, both the CDU and the SPD have seen their national ratings plummet further since the federal election in September 2017. Last week, a nationwide Emnid poll found that the support for the CDU/CSU has shrunk to a record low of 24% (down from 32.9% in September 2017), while the SPD dropped from 20.5% to a lowly pitiful 15%. The AfD is now polling ahead of the SPD at 16%. The grand coalition of – the CDU/CSU and the SPD together now account for 39% of national support, a big fall from the over 67% support they enjoyed just over a year ago. German voters continue to show their disappointment with the open border policy of Merkel. A yearning for change is evident among CDU and SPD supporters, who feel betrayed by their leaders.
The move to the right (and in some cases far right) in the recent elections in the US, UK, Germany, Austria, Netherlands, Italy, Sweden, Poland, Hungary and so on, indicates that, in the Western economies at least, the leftist parties have become rigid ideologues that no longer truly represent their people. Voters are therefore abandoning them and are willing to try new and untested political parties and personalities. This polarization is set to continue and in Europe, the full effect of it will be felt in the upcoming European elections in May when the “populists” from across Europe take their seats in the European Parliament in Brussels in increased numbers. Until such time as the main political parties stop undermining their own people and betraying their values, things will only get worse and, in some countries, much worse than today.
Merkel is powerless to stop the erosion of support. This week she announced that she would not seek re-election as Chair of her party a post she has held for the past 18 years. But will that be enough? Can she cling on as Chancellor for the rest of her term ending in 2021? I believe Merkel is on borrowed time. Giving up the CDU chair will increase the pressure on her to resign as Chancellor before her term ends. So, what happens when she goes?
In the medium term, it will only increase worries as there is no clear successor to Merkel and therefore we won’t know what the new Germany will look like. A weak or uncertain Germany is bad for Europe. Serious decisions remain to be made on the future of the Eurozone: Migration, defence, the European Monetary Fund, the Italian budget deficit and other issues – let alone negotiating Britain’s exit from the European Union (EU). If Germany gets wobbly, the EU could drift untethered and directionless and stumble from one crisis to another.
Brazil turns right
Latin America’s biggest economy and the world’s fifth most-populous country, Brazil, has a new President – Jair Bolsonaro, a former army captain. Bolsonaro beat his left-wing rival Fernando Haddad by 55%-45%. For the first time since 1989, neither the Workers’ Party (PT) nor Brazil’s other political heavyweight, the centrist Brazilian Social Democracy Party (PSDB), has won the Presidency.
Bolsonaro is quite a controversial figure with polarizing views on many a topic. Perhaps a lot of it is loose electoral talk, but the fact that Brazil still voted him in says how tired Brazilians are of the last 13 years of PT rule, during which corruption, debt and the deficit soared and Brazil fell into its worst recession in more than a century. There was a feeling that if the PT returned to power, it would pick up where it left off and eventually turn Brazil into another Venezuela.
Brazil is still struggling to return to strong growth after GDP fell -3.9% in 2015 and -3.5% in 2016.
The recovery has been anemic and Brazil is struggling with unemployment of +12%, a high debt/GDP ratio of 80% and a worrying budget deficit of +7% of GDP.
The profligacy and corruption of 13 years of left wing government is largely responsible for the mess that Brazil is in. The last three Presidents have all been implicated in scandals and bribery. Luiz Inacio Lula da Silva, president from 2003–2011, was sentenced in July 2017 to nine and a half years in prison for corruption and money laundering. Dilma Roussef who succeeded Lula in 2011 was impeached and then removed from office in 2016. Michel Temer, Rousseff’s one-time running mate and Vice President took office in August 2016 after Rousseff was impeached and has since been charged with taking bribes. Brazilian voters have been so angry at the last 13 years that some took to referring to Bolsonaro as the best available “pesticide” or “chemotherapy” Brazil now has to protect itself from the PT’s return.
Mansueto Almeida, an economist at Brazil’s Finance Ministry explains that approximately two-thirds of the country’s budget goes towards paying old-age pensions, public health care and the payroll of Brazil’s bloated public sector. If this continues then by 2020 those liabilities will have grown so much that there will be nothing left over for discretionary spending items such as roads, new hospitals or police equipment. A debt crisis is looming. Brazil is one policy mistake away from ushering in a return of the IMF.
This election, therefore, was a choice between more of the same or a course correction and revival. Brazilians very wisely chose the latter. Reform will not be a cakewalk but more of the failed policies of the PT sure would be a road to perdition. While the media likes to label Bolsonaro as far right, for many in Brazil, Bolsonaro whose middle name means “Messiah”, is a saviour.
Bolsonaro has pledged to clean up politics, crack down on crime, and set a new direction for his country. “We cannot continue flirting with socialism, communism, populism, and leftist extremism … We are going to change the destiny of Brazil,” Bolsonaro said in an acceptance address, promising to root out graft and stem the tide of violent crime. Bolsonaro’s chief economic adviser is Paolo Guedes, a Chicago University-trained economist and investment banker advocating radical privatization and small government. However, the new President’s success will depend on his ability to unify a deeply divided nation and to find a majority in Congress in order to implement his reform agenda. While Bolsonaro’s Social Liberal Party is now the second-largest party in the lower house, it still has only 52 out of 513 seats. The Lower House remains split between ten parties that account for around 60% of the seats. There is a similar split in the Senate. Hence, forming a coalition will likely be tough. Bolsonaro backs an independent central bank, privatization and deregulation, fiscal austerity, opening the economy, and a move away from failed industrial policy. If he delivers even half that, Brazil will be the winner. Watch out for the Brazil equity index BOVESPA and the Brazil ETF (EWZ US).
Markets & Economy
Last week the equity market sell-off that so far had only hit Emerging Markets and Europe reached US shores and as it has wiped out all year-to-date gains of the S&P 500 (SPX) index, while leaving other indices in a sea of red (see table below)
So where to from here? What is the level that the SPX could fall to before it becomes an attractive buy?
If the sell-off in the US equities continues, it will be a case of throwing the baby out with the bathwater. US GDP expanded at the rate of +3.5% per annum in the third quarter. Consumer spending rose +4%, a stronger rate than the prior quarter and government spending picked up as well. The US economy is set to grow above a +3% rate during 2018. That hasn’t happened since 2005. At the same time, inflation cooled in the third quarter i.e. it should ease the pressure on the US Federal Reserve (Fed) to continue raising interest rates.
While it’s easy to turn bearish if the market is at an all-time high, there’s one thing I find contradictory about the bearish commentators out there. The same folks who say growth has peaked, seem to suggest that the Fed will keep increasing rates and therefore the sell-off will continue. Why on the earth would the Fed keep increasing rates if growth has peaked?
I don’t disagree that US growth may be easing with the second quarter growth of +4.2% being the peak quarterly growth of this business cycle – when the biggest impact of the Trump tax cuts was felt. If that is the case, then the Fed will again find it difficult to stay on the rate hike path i.e. equities should get support. A dovish hike in December, where the Fed raises rates but lowers the forward rate projections (dot plot) would be supportive for US equities as well as Emerging Market equities and bonds hit by a strong USD. If growth and inflation both fall back to +2% by mid next year then I would expect this rate cycle to top out at +3% and not +3.5%, as currently anticipated. A long pause from March – September 2019 would be enough to get equities higher again and steepen the yield curve for banks’ earnings to do well.
There’s one more thing to watch out for. Markets may be underestimating the amount of government spending that will come from already approved budget appropriations and we saw a sign of this in higher government spending figures in Q3 GDP released last week and mentioned above. A capital-spending program by the government would encourage companies to invest in capital and production in anticipation of nominal growth rather than financial engineering.
Based on the current earnings number of $175-$179 Earnings per Share (EPS) for 2019 and $165 in a bearish case, there’s strong support for the SPX at the 2650 level, i.e. at a P/E of 16. I expect the SPX to bounce back to the 2850 level and a dovish Fed in December could set it nicely for a test of 3000 in early 2019.
And let’s not forget that President Donald Trump is talking of another tax cut. The poll numbers for the US midterm elections have started moving back in favour of the Republicans and they look to retain the Senate comfortably. Generic ballot numbers still indicate a 50/50 House of representatives, as we head into the final stretch with the Democrats losing steam as more voters return to the red corner.
The next area to focus on would be the strength of the US dollar, with way too many Fed rate hikes priced in for 2019, if growth is indeed slowing. I would, therefore, increase exposure to Emerging Market bonds and equities in anticipation of US Dollar weakness. Also I would recommend a move into more value sectors – Energy, Industrials, and Financials.
While I am not concerned about the US economy in the short term, I am concerned about it in the medium to long-term.. Trump’s tax cuts and an increase in government spending means that, in 2020, the US will be borrowing more than $1 Trillion plus while the US economy will only grow by $400 billion (taking GDP growth at +2% for 2020). In other words, the US will be going deeper into debt at the rate of $600 billion a year. While stimulus-driven growth that borrows from the future is fun in the short-term, it’s not so good in the long run. So yes, 2019 and definitely 2020 will be big worries for the US economy, and the world, if growth slows down.
Meanwhile, in Europe, stocks fell as the tussle between Italy and the EU intensified. The EU took the unprecedented step of rejecting Italy’s draft budget as incompatible with the bloc’s rules on fiscal discipline. Yields on 10-year Italian government bonds have risen to +3.6% from less than +2% in May. European Central Bank (ECB) President Mario Draghi has refused to intermediate, however, he reiterated that Italy and the EU would come to an agreement. “I’m confident an agreement will be found,” Draghi said of the standoff.
Of course, nobody expected the EU to give in immediately, but they will give in eventually. The higher deficit may be the only way to avoid an economic crisis in Italy. Italy has a growth problem and needs the deficit spending to support growth. Arguing over whether the deficit should be -2% or -2.4% of the GDP is like arguing about what music to play on the Titanic after it hit the iceberg. Even if Italy accepts the -2% target, the deficit may slip to over -2.5% or even -3% if growth slows down further.
French and German banks are again exposed to Italy in a big way (chart below) as they were to Greek banks. French banks look particularly exposed. As of June, French institutions had some $316 billion (over 14% of France GDP) in Italian investments, according to the Bank of International Settlements (BIS). That’s much more than they ever had in Greece. German banks’ claims on Italy, at $91 billion (3.2% of Germany’s GDP), are smaller but still significant.
I continue to be long US equities, with sector preferences for Technology (XLK), Financials (XLF), Energy (XLE) and Industrials (XLI). I also recommend increasing exposure to European equities now that they have fallen to oversold levels – Financials, Industrials, Healthcare, Autos and Luxury stocks are my favourite sectors. An increased allocation to Emerging Markets equities is also recommended
And finally what happens after we’ve had a bad October? How soon does the SPX recover? Here are some stats from S&P 500’s history dating back to 1928, for October sell-offs of more than -4%:
In terms of stocks I like : VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Valeo (FR FP), Ford (F US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US).
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
I can understand why the Brexiteers are opposed to the UK’s Chequers proposal, but I do not understand the European Union’s opposition to it. The Chequers deal would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations, if the UK were not seen as having control of domestic rules or laws or being a credible negotiating partner. In my opinion, the EU, in pushing the envelope and rejecting the deal, has miscalculated. The Chequers deal is better for the EU than a “no-deal” or any other deal frankly. UK Prime Minister Teresa May will now do well to turn this rejection of her proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. Despite the antics and acrimony, I do see the UK and the EU concluding a deal, and it will likely be before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on Word Trade Organisation guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU.
Chequers chucked, so what next?
That there was no deal on the UK’s Chequers proposal at the European Union (EU) Summit in Salzburg last week, shouldn’t have come as a surprise to anyone. The half in/half out deal that this proposal called for, was opposed both within the UK and in Brussels – with only Prime Minister Theresa May pushing for it. The Chequers proposal would provide the UK access to the EU “single market” on goods after Brexit, while services would be governed under different rules. In return, the UK would accept the EU’s “common rulebook” – standards governing manufactured and agricultural products.
Leading Brexiteer Boris Johnson described this proposal as a “suicide vest” for the British constitution. The European Research Group (ERG), a grouping of Tory Eurosceptic Members of Parliament (MPs), who number close to 80, had warned that they would vote against the Chequers plan in Parliament. Brexiteers were opposed to the Chequers proposal as it would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations if the UK were not seen as having control of domestic rules and laws or being a credible negotiating partner. Michel Barnier, the Chief EU negotiator on Brexit was opposed to the Chequers proposal too. Barnier remarked “les propositions sonts mortes (the proposals are dead).”
I can understand why the Brexiteers are opposed to the Chequers proposal, but I do not understand the EU’s opposition to it. In my opinion, the EU, in pushing the envelope, has miscalculated. The Chequers deal is better for the EU than a ”no-deal” or any other deal frankly. The Chequers deal would have essentially kept the UK in the single market for goods (where the EU has a trade surplus of +£100 billion with the UK) and would have kept the UK out of the single market for services (where the EU has a deficit of -£28 billion). The EU would thus continue to sell goods and keep its huge surplus in goods intact. But the EU doesn’t do economics, it does ideology. Ideologically, Brussels saw the Chequers proposal as breaking up the “single market.” In their opinion, enjoying the benefits of the single market (albeit only in goods) without free movement of people would make Brexit look easy. Brussels worried that more copycat departures could follow and the EU would eventually collapse. I disagree with this thinking entirely.
“In my opinion, the EU, in pushing the envelope have miscalculated. The Chequers deal is better for the EU than a no-deal or any other deal.”
Just because the UK is leaving the EU and can make a success of it, it doesn’t mean that others will follow suit. If leaving and making a success of it were so easy then Greece and Italy would have left the EU long ago, reclaimed their currencies back and embarked on efforts to reduce crippling debt and rebuilt their economies. It has taken the UK over a decade to organise an “in-out” referendum since it was first mentioned in 2007. It will take a good few years for the UK to chart a path independent of the EU despite the UK having an independent monetary policy and several opt-outs in its current EU membership. Leaving is one thing and making a success of it is quite another. Out of the twenty-eight EU nations, eighteen are net recipients of EU funds, so they are not going to leave the “free money” anytime soon. Of the ten who are the net contributors Germany, the UK, France and Italy contribute the most, and are candidates to leave in a theoretical discussion. However, Germany is the biggest beneficiary of EU project so it won’t leave (until the cost of keeping the EU together outweighs its benefits). France punches above its weight and the EU helps it do it, so they wouldn’t leave either. Italy with over €2.3 trillion of debt and moribund GDP growth has much to ponder before they can consider leaving the EU and the Euro.
The divide between the EU and the UK is one of history and beliefs. It’s about Catholicism vs. Protestantism as political scientists Brent Nelsen and James Guth describe in their book, “Religion and the Struggle for European Union.” Broadly speaking they suggest, Catholics favour the EU more than Protestants. These attitudes were forged in the Reformation that took place in 16th Century Europe. It led to the development of two different approaches to governance in Europe. Catholics see Europe as a single cultural whole that ought to be governed in some coordinated way. Protestants, on the other hand, see the nation state as a bulwark against Catholic hegemony and a guarantor of individual liberty. On the Continent, people are used to the State/supranational bodies running the country. Brussels taking over ”governing” in the 20th Century is no different than Imperial France or the Austro-Hungarian Empire that ran Europe in the 18th and the 19th Centuries. It’s a continuation of history. If you suggest this to Europeans, they may not see it this way. They will tell you that Europe has come far, but the reality is they haven’t come that far and history is not on their side. Their acceptance of the EU is far deeper and not based on reason but a habit. A habit formed over many centuries.
So where do we go from here?
PM May will now do well to turn this rejection of her Chequers proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. It’s time to move on to a “Canada +” deal. At its most basic, a Canada-style deal, is the UK striking a free trade deal with the EU after Brexit along the lines of the agreement the EU recently signed with Canada. This would remove most, if not all, customs tariffs on goods sold between the EU and the UK and potentially allow some market access for services.
So, will the EU accept it readily? Not really. In the EU’s infinite wisdom, this solution would not solve the problem of the Irish border. Brussels fears that Ireland could become a backdoor into the EU market for goods from around the world that may not comply with EU’s standards and tariffs. So, for a Canada-style deal to happen, the UK would have to give assurances on regulations and standards the EU holds dear. If the EU is not assured, it would effectively put a customs and regulatory border in the Irish Sea, something that is unacceptable to PM May. The backers of a Canada-style deal reject the EU’s reservations about it and have long maintained that with the use of technology it would be possible to ensure that goods crossing between Northern Ireland and the Republic fulfil customs requirements without the need for physical infrastructure at the border. The EU physically checks only around 3% of imports, the rest is done electronically and with mutual recognition of standards. So, it is not a big problem to do the same with the Northern Ireland- Republic of Ireland border.
“An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching”
As I have said in the past, despite the antics and acrimony, I do see the UK and the EU concluding a deal most likely before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on WTO guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their close history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU. It remains an issue of mutual recognition of standards. Besides Brexit is not merely a matter of economics. The UK may be leaving the EU, but it is not leaving the US-led Western alliance. The UK’s role is key to sustaining US support for Europe and the guardian of peace in Europe – the North Atlantic Treaty Organisation (NATO) that US President Donald Trump has threatened to withdraw from. An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching. This is well understood in Brussels.
As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. An EU which hasn’t bothered to get its treaty ratified by member states (because it can’t be sure of the outcome) and ignored the result of previous referendums in member states, is galaxies away from a Europe a la carte. Those seeking a second referendum are wasting their and everyone’s valuable time. They are well advised to offer their time, money and services to charitable work.
Markets & Economy
As expected the US Federal Reserve (Fed) raised interest rates by +0.25% Wednesday, as it continues to gradually roll back its policies of easy-money. This lifts the Federal-Funds Rate to between +2% and +2.25%. The increase, is the third this year and the eighth since the Fed began to raise rates in late 2015. For the first time since 2008 the benchmark rate is above 2% and also above inflation, measured by the Fed’s preferred gauge, Personal Consumption Expenditures (PCE) which excludes the volatile energy and food categories. The so-called core PCE index rose +2% in July. Fed Chairman Jerome Powell remarked, “This gradual return to normal is helping to sustain this strong economy for the longer-run benefit of all Americans.” Trump, in a press conference later said he was “not happy” about the Fed raising rates. He however added, “They are raising them because we are doing so well” and that higher rates weren’t all bad because they could help Americans who rely on interest savings for income.
Between this rate increase and the Trump tax increase, I mean the Trump tariffs, the US economy risks slowing down. How soon that happens will depend on the level of tariffs implemented and how quickly the Fed continues to raise rates. The Fed hinted it will raise rates one more time this year and by one percentage point through next year. If Trump raises tariffs to 25% and they stay there, and the Fed Funds Rate goes up to 3% or more, then recession fears will increase. For now, I have no such fears.
While the China-US trade war has dominated the narrative over the last quarter, rising oil prices are now getting everyone talking. Impending sanctions on Iran have lifted crude prices. Trump has called for the Organization of the Petroleum Exporting Countries (OPEC) to increase the oil supply and stop “ripping off the rest of the world” by pushing oil prices higher. However, at its meeting in Algiers on Sunday, OPEC and Russia reiterated that they want to adhere to current production quotas first implemented at the start of 2017. If the glut of oversupply goes, demand continues to increase and US oil inventories fall – then US sanctions on Iran and a Trump defiant OPEC spell higher oil prices. Brent could easily get to $90 and over in the short term.
Regular readers of this newsletter will know that I have been bullish on US equities and overweight US equities for a long time now and even during all of this year, despite the market talk of recession and an impending market correction. The S&P 500 index (SPX) has not disappointed and continues to pass the “back to school” test as we enter autumn after a volatile summer. The SPX broke out to a new high (chart above) at the end of August and pulled back in early September. Crucially the pullback found support right at its prior highs from January. After holding that level, the SPX has continued to trade higher. If you are a chartist, it doesn’t get much more textbook than this. With the US economy growing at over +3.5%, no signs of a recession on the horizon and a measured escalation of the US-China trade war, the SPX has legs to continue reaching new highs. Besides, many investors and commentators are still sceptical about the SPX rally and that’s a good thing. You should worry when everyone is bullish.
While the SPX index has recovered nicely from a pullback early this month and is up +9% Year-To-Date (YTD), Europe’s flagship Euro Stoxx 50 (SX5E) Index has slipped down further, -2.3% YTD, and so has the MSCI Emerging Market Index, -10% YTD (table below). The SX5E could have been worse off had we not seen a rally in European stock (particularly financials) on the back of reducing confrontation between Italy and the EU over the Italian budget. The Italian government officials from both parties – 5 Star Movement and the League – have pledged to respect EU rules limiting deficits, after a squabble to break EU rules on fiscal discipline led to heavy selloffs of Italian bonds over the summer.
The prospect of a quick resolution to the US-China trade war has dimmed. Trade tensions between the US and China will be a drawn-out affair as this is more than a trade spat. It’s about global influence and leadership. Jack Ma, Alibaba’s Executive Chairman rightly remarked – “It’s going to last long, it’s going to be a mess. Maybe 20 years.” Early this week China cancelled trade talks set for this month and the US imposed 10% tariffs on $200 billion of Chinese exports to the US. China responded with tariffs on $60 billion of US exports to China. This is likely to beget US tariffs on the remaining $267 billion of Chinese exports to the US i.e. just about all imports from China would face a tariff going forward.
The war of words will continue and as Winston Churchill and Harold Macmillan used to say “Better jaw-jaw than war-war.” I think the world and markets can endure a war of words, however long this takes. The US is the declining power and China is the rising power, but there needn’t be a war. The sensible thing for the US to do would be to agree on a deal with China and open China’s market to US products. China is shifting its economy from being the world’s largest exporter to the world’s largest consumer. Speaking at the World Economic Forum (WEF) early this year Chinese President Xi Jinping remarked that over the coming five years, China would import $8 trillion of goods. US companies want in on this. Trump may have his own ideas but he is not an ideologue. You can see that from the exemptions granted to a range of products (particularly Apple’s products) in the latest round of tariffs imposed by the US. US businesses and indeed European businesses are not ready to forfeit this opportunity of China trade – an emerging Chinese middle class of 300 million people with average income growing at almost double digits. The US will have to learn to live with reduced influence as China rises until such time as China has its own political troubles. The US doesn’t have to worry about any other power eclipsing it. A declining and bureaucratic Europe will never be much of a challenge to the US and Russia may be a military power but it will never be an economic power given the paranoia and mistrust that grip the nation and its leadership.
Having said that, the EU’s announcement this Tuesday that it would establish a special payments channel to maintain economic ties with Iran is significant and it may be a first step to challenging the supremacy of the US Dollar. Should America be worried? Not so fast. Can American counter the threat? Absolutely. You can do business with Iran or you can do business with the US, but not both. The risk of losing access to the $20 trillion US economy and being cut off from the Western financial system can sober any business and the next time the ECB comes to the US Federal Reserve window to arrange Dollar swap lines, you can be sure what the response will be. European banks will be foolish to provide payment options to companies seeking to do business with Iran. It will be like picking up pennies in front of the steamroller. The US Dollar will meet its challenge but this is not the moment.
After having a bad first half of the year, Q3 has been extremely good for the Healthcare, Industrials and Financial sector stocks. As the table below indicates, almost all of the year-to-date performance for Healthcare stocks has come in Q3. This good performance is set to continue. Healthcare stocks are seen as safety stocks and as the rally gets old, defensive sectors – Healthcare, Consumer Staples, and Utilities will see increased inflows. Again, as I have said above, I do not see a US recession on the horizon and an inflation surprise to the upside also looks distant.
I continue to be overweight US stocks with sector preferences for Technology (XLK), Financials (XLF), Healthcare (XLV) and Industrials (XLI). I remain underweight Europe and underweight Emerging Markets.
In terms of stocks I like : VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels, US President Donald Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. Patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to. The US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. A second wave of direct payments to farmers is likely to follow if tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price. As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, Americans will be faced with the question – at what price patriotism?
At what price patriotism?
This week we learnt that the US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. Furthermore, the US Department of Agriculture (USDA) could decide by December to make a second wave of direct payments to farmers if damages from trade tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price.
Last year, Michael Anson, who works in the Bank of England’s (BoE) archive along with Norma Cohen, Alastair Owens and Daniel Todman from Queen Mary University of London, made a startling discovery – the spectacular failure of UK’s first bond issue of the Great War in 1914 and the extraordinary role of the Bank of England (BoE) in the cover-up that followed.
In the early days of World War I, the British government sought to raise £350 million (about £38 billion in today’s money) through the issuance of “war loans.” Britain’s banks agreed to subscribe for £60 million and the BoE agreed to take £39.4 million on its books. The remaining £250 million was expected to be sold to the public by appealing to their patriotism. The issuance went ahead and the bond sale was heralded as a great success. The Financial Times reported on 23 November 1914 (clip below) that the Loan had been over-subscribed. It gushed – “by motives of patriotism no less than by thought of securing a good investment, the British Public has offered the government every penny it asked for – and more ….and still the applications are pouring in!”
Source: The Financial Times, 23 November 1914
The reality, however, couldn’t be more different. The public demand for “War Loans” was woefully low and amounted to a grand total of £91 million i.e. one-fourth of the amount the government wanted to raise from the public by appealing to their patriotism. At the time, if this failure had become public knowledge, it would’ve crashed the price of existing UK sovereign bonds and endangered any future capital raising by the British government thus undermining its preparedness for what was to follow in the Great War. The BoE officials, therefore, hatched a plan to cover up the shortfall. The BoE’s then Chief Cashier Gordon Nairn, and his deputy, Ernest Harvey, bought the securities in their own names using the bank’s money and the bond holdings were classified as “Other Securities” on the bank’s balance sheet rather than as holdings of government securities. The British Government of the day led Prime Minister Herbert Henry Asquith and his Chancellor David Lloyd George then declared the bond issuance a success and hailed it as a sign of patriotic fervour among the British people. And you thought “Fake news” was something new?
In a secret memo to the then Treasury Secretary John Bradbury, economist John Maynard Keynes called the effort of the BoE to step in and buy the unsubscribed bonds for its own account as a “masterful manipulation.” Today, we, of course, call it Quantitative Easing (QE) and we don’t make any effort to hide the “manipulation.”
Additionally, the funds that were raised from the public came from a very small group of financiers, private individuals and shipping companies that were among businesses benefitting from surging war demand for their services. Half of all investments were for £200 or less i.e. most of the wealthy British would rather have put their country in peril than part with their money. Patriotism was not enough.
Every patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to.
I continue to believe that there won’t be a full-fledged trade war between the US and China as it is not in either one’s self-interest. Over the weekend we learnt that US President Donald Trump had reached a “trade deal” with Mexico. As we know, the talks between the US and Mexico appeared close to collapse many times during the past 12 months. China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels in the US, Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. GDP growth is forecast to ease to +2.9% in the 3Q and +2.6% in the 4Q of this year. Quarterly growth is expected to average just +2.2% in 2019. Besides, China is rapidly diversifying its economy and its reliance on the US. A rising debt and a trillion-dollar deficit that the US faces can easily be exacerbated with tariffs and the window of opportunity could close sooner than Trump expects.
As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, the Americans like the Brits in 1914 will be faced with a question – at what price patriotism?
Turkey’s crisis is not a systemic risk
The big news in markets recently has been Turkey. The Turkish Lira has depreciated by over -40% this year, the current account deficit has widened to -6% of GDP and inflation runs at over +15%. Whilst it’s easy to draw parallels with the 1997 Asian Thai Bhat crisis and fear for the health of Emerging Markets in general, the only commonality between the two episodes is that it was a period of big capital inflows and then outflows, but the underlying conditions in Emerging Markets today are very different.
Robust economic growth over last two decades, floating exchange rates, high foreign reserves, and greater transparency have reduced the need for abrupt adjustments. Low single-digit current account deficits and in some cases (South Korea, Taiwan, Hong Kong and the Philippines) surpluses, are insulating these economies and the risk of contagion has consequently been reduced. Turkey defaulting on its debt – private or public – is very unlikely to cause a repeat of the Emerging Market crisis we saw in 1997. The problem Turkey faces is of its own making. A sharp increase in credit growth and government spending, financed by short-term capital flows (70% of Turkey’s debt is denominated in US Dollars and Euros) led to a rapid worsening of its current account deficit and left it vulnerable to both the USDTRY exchange rate and outright funding risk. Turkey’s crisis is not a systemic risk.
Turkey, however, does pose a risk to the European economy through its links with European banks and geopolitics. Spain’s second-largest bank Banco Bilbao Vizcaya Argentaria (BBVA) is the most exposed bank in the European Union (EU). BBVA owns 49.9% of Turkey’s Garanti Bank, the second largest private bank in Turkey. Unicredit, Italy’s biggest bank owns around 40% of Yapi Kredi (YKGYO.IS), Turkey’s fourth-largest bank, through a local joint venture. ING, the Dutch bank has a fully-owned subsidiary in the country, ING Turkey. BNP Paribas, the French bank controls 72% of the Economy Bank of Turkey (TEB), partly through a local joint venture. HSBC operates HSBC Turkey in the country. Of these five European names, only BBVA looks at risk of any meaningful capital impairment from the economic situation in Turkey. Garanti accounts for around 13% of BBVA group’s earnings. Of greater concern are the implications on geopolitics. An economic meltdown in Turkey could easily spill over into Europe and cause further unrest in the Middle East thereby triggering a new wave of immigration to Europe. Wary of this risk, Berlin is now considering providing emergency financial assistance to Turkey.
Markets & the Economy
Other than Turkey, it has generally been a positive time in the markets if you were overweight US equities. The S&P 500 index hit a new all-time high and is now above the 2900 level. The US Technology index, NASDAQ is also trading at an all-time high and is up +17.5 this year. Meanwhile Europe’s flagship Euro Stoxx 50 Index is down -1.8% and the MSCI Emerging Market Index is down -7.6%. The chart below details the performance of other key Equity Indices.
The Federal Open Market Committee (FOMC) minutes released for the July/August meeting was very upbeat and signalled more rate hikes this year. Last week, US Federal Reserve Chairman Jerome Powell, speaking at the annual symposium in Jackson Hole, Wyoming defended the Fed’s strategy of gradually raising interest rates even as he was criticised by Trump for moving too quickly. Powell reiterated his view that gradual hikes in rates will be needed as long as the economy remains healthy. “There is good reason to expect that this strong performance will continue” he said. At a fundraising event the week before last, Trump remarked that he was “not happy” about interest rate increases which the he feared would cool off the fast-growing economy. Before Trump, the last President to publicly call for lower interest rates1 was George H.W. Bush during his re-election bid in 1992. Bush later blamed then Fed Chair Alan Greenspan for his election defeat and said – “I think that if the interest rates had been lowered more dramatically that I would have been re-elected President because the [economic] recovery that we were in would have been more visible. I reappointed him [Greenspan], and he disappointed me.” Before that in the 1970s, political pressure on former Fed chairmen William McChesney Martin by the then President Lyndon Johnson and later on Arthur Burns by the then President Nixon (before his 1972 re-election) led to inflation surges as rates were kept low. The Fed later came to view these as a costly mistake. I do not expect the Fed to yield to political pressure and make the same mistake. The Fed has raised rates twice this year, most recently in June to a range between +1.75% and +2%. I expect the FOMC to raise rates by +0.25% when they meet in four weeks’ time.
Last week also saw headlines – “The end of Greece’s marathon bailout.” Only in the EU could a bailout be described as ended by completely ignoring the over €330 billion that has to be repaid by 10 million people who don’t like paying taxes. Euphoria in Brussels and official press releases rushed to claim Greece had exited its multi-year bailout program and it was once again a “normal” country. If only that were true. Taxes and regulatory burdens put on Greece as part of the bailout program have made growth unstainable and economic prospects still remain grim. Besides the Value Added Tax (VAT), small business tax rates, fresh pension cuts and new punitive income tax rates for the poorest are all scheduled for 2019. The charade of interest payment deferrals and extending the maturity of the debt can only go so far. Give it a few months and Greece will be back in the news seeking a fresh bailout. Greece is like Groundhog Day but without the happy ending.
The European Central Bank (ECB) has said it expects to phase out its bond-purchase programme by the end of the year, although it has also signalled that its policy rates, which include a negative deposit rate, would stay where they are at least through next summer i.e. the gulf between the ECB and the Fed policy rate will only get wider. The Eurozone still needs stimulus whereas the Fed plans to press ahead with raising rates. I am not bullish on the Eurozone growth and don’t see how the ECB will be able to end its QE policy this year in face of a growth slowdown and the fear of Trump tariffs hanging like the sword of Damocles over the head of the EU.
I continue to remain Underweight Europe and overweight US equities with a bias to Technology (XLK), Healthcare (XLV), Consumer Discretionary (XLY) and Financials (XLF). However, in Europe, few stock-specific trades are still worth holding or adding to. Luxury stocks like Louis Vuitton Moët Hennessy (LVMH) and infrastructure and industrial stocks (Vinci, Eiffage, Siemens, Bouygues) offer a good investment opportunity for completely different reasons. The world’s well-heeled shoppers are doing just fine and are unruffled by trade fears as they continue to splurge on handbags, jewellery and fine wines. Revenue at LVMH in the first half of this year hit €21.8 billion, up 10% compared with the same period a year ago and net profit jumped 41% to €3 billion. The case for industrial stocks is boosted by the urgent need for Europe to upgrade its infrastructure in the light of the catastrophic bridge collapse in Genoa. French President Emmanuel Macron is under pressure to step up spending on infrastructure after a government report warned that approximately 840 road bridges in France are in danger of collapse.
I was on Bloomberg TV last week for an hour discussing my views on Brexit, the US economy, European Banks and the crisis in Turkey. You can watch it at this Bloomberg Surveillance link (skip to 57 min).
In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)
1 Greenhouse, S. (1992, June 24). BUSH CALLS ON FED FOR ANOTHER DROP IN INTEREST. The New York Times. Retrieved from https://www.nytimes.com/1992/06/24/business/bush-calls-on-fed-for-another-drop-in-interest.html
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. The US became the dominant economic power in the early 20th Century by having high protective tariffs and this served as a model for later day mercantilists – Germany, other European nations and most recently, China. George Washington, the first President of the United States, not only supported the protection of infant US industries, but also set an example by “buying American.” The US Presidents that followed Washington carried on the protectionist policies as they built America in the 19th Century. The Republican Party dominated the US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. History is a great thing. One just has to look back far enough to cure one of all prejudices.
Let’s face it, there is no such thing as “free trade”, only good or bad trade deals. The debate about “free trade” and capitalism can be neatly divided into two distinct camps – Liberalism and Mercantilism. Liberals see the State as predatory and Business as profiteers and the two shouldn’t be allowed to work together to the detriment of the individual consumer. Liberalism places the individual’s interest at the heart of economic policy-making, with the objective of increasing household consumption i.e. giving the individual consumer easy and unhindered access to the cheapest possible goods and services. Mercantilists, on the other hand, don’t see this separation between the State and Business as a necessary condition to benefit the individual consumer. They see the two as allies and emphasise that the aim of economic policy-making is to improve the productive capacity of the nation in pursuit of economic growth, power and independence. For the Mercantilist, a sound economy requires a sound production structure within the nation and not a cheap production structure abroad. Mercantilists believe that a robust domestic consumption can only be underpinned by high employment at appropriate wages and not cheap goods from abroad. What does the Liberal like to call the Mercantilist? A Protectionist. Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. It became the dominant economic power in the early 20th Century by having high protective tariffs and it served as a model for later day mercantilists – Germany, other European nations and most recently, China.
I often get a strange look from my friends and colleagues when I make the observation that America was a “protectionist” nation. Perhaps you are frowning at me now as well. However, please indulge me and keep reading.
From the time of its Independence, through the Civil War in the 19th Century and the Great Depression in the 20th Century, the United States of America followed a “protectionist” policy as it looked to get the better of Great Britain and establish itself as the dominant economy in the world. George Washington, the first President of the United States from 1789-1797, not only supported the protection of infant US industries but also set an example by “buying American.” He said – “I use no porter [ale] or cheese in my family, but such as is made in America.” Alexander Hamilton, President Washington’s Treasury Secretary and the founder of America’s financial system argued in favour of a national industrial policy that inspired the likes of American economic nationalists Daniel Raymond and the German-American economic thinker Georg Friedrich List. Raymond believed that the “protective tariff represented national interests and that it allowed for the nation’s people a leverage, and special treatment granted to them over foreigners” in the fields of domestic commerce and industry of the nation. List, whose vision of a united Germany with a protected market was realized later in the 19th Century, believed that “the cost of a tariff should be seen as an investment in a nation’s future productivity.”
The US Presidents that followed Washington carried on the protectionist policies, as they built America in the 19th Century. The Republican Party (led by men such as Lincoln, McKinley, Roosevelt, Harding, Coolidge and Hoover) dominated US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. The US Economist Joseph Schumpeter called tariffs the “household remedy” of the Republican Party. It wouldn’t be too off base if instead of calling the GOP – the Grand Old Party, one called them – the Grand Old Protectionists. Tariffs were used both to generate revenues as well as to protect the American economy from British and European imports. President Franklin Roosevelt summed it up well when he declared, “Thank God I am not a free-trader. In this country, pernicious indulgence in the doctrine of free trade seems inevitably to produce fatty degeneration of the moral fibre.”
America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. It ran a trade surplus for over 30 years selling goods and services to Europe, Japan and Asia whilst helping them re-emerge from the devastation of the Second World War. The love for “free trade” didn’t last long, however. The latter half of 1970s and early 80s saw massive capital outflows from the US and migration of manufacturing and this turned the US from a trade surplus to a trade deficit nation. As trade and budget deficits mounted and Japan achieved a rival status, America strong-armed Japan into signing the “Plaza accord” in a move to shrink the US trade and budget deficits. The US had a temporary respite and deficits began to narrow in the 90s until China came along. The accession of China into the World Trade Organisation (WTO) accelerated the US trade deficit as Liberalism (Clinton, Bush, Obama) won and Mercantilism/Protectionism lost. Now, the US is back to protectionism once again and once again under a Republican President, Donald Trump. China is accused of “protectionism” and the US is heralded as a “free trader.” History is a great thing. One just has to look back far enough to cure one of all prejudices. In that, I am reminded of this Marcus Tullius Cicero quote: “To be ignorant of what occurred before you were born is to remain always a child.”
From the US point of view, over three decades of liberalism have eroded its economic might and a return to mercantilism, as Trump proposes, is like a reversion to the mean. However, can this be achieved? Is the US ready to pay the price it will take to return to its mercantilist past? That’s the trillion-dollar question. If tariffs start biting US consumers, Trump’s “Make America Great again” could simply turn into “Make America Grate.”
Markets & the Economy
Things are stirring at the Bank of Japan (BOJ). Under its “yield curve control” (YCC) policy, the BOJ committed to holding 10-year yields at around 0%. This policy has been around since September 2016 and has been successful, thus far, in staving off deflation and keeping the Japanese Yen (JPY) weak. Over the weekend, there were reports that the BOJ was looking to move this target yield higher. That was enough for the market to sell the 10-yr Japanese Government bonds (JGBs) and yields spiked up by 10 basis points, which is a big move in Japan. The yield on 10-year JGBs rarely moves more than one basis point during a day’s trading. The BOJ had to step in to prevent more of a sell-off and it offered to buy unlimited amounts of the bonds at a yield of +0.11%. This had the desired result of preventing any more sell-off in the JGBs and in fact, the Central Bank didn’t wind up having to buy any bonds. The BOJ is trying to steepen the yield curve and help Japanese banks so they can in-turn boost the economy by making more loans. It’s a dangerous game, as the BOJ is nowhere near achieving its +2% inflation target and if the market interprets this as the BOJ being a step closer to unwinding its aggressive monetary stimulus – then the Yen will rally and undo years of BOJ stimulus. The BOJ is holding a two-day board meeting beginning on July 30. I do not expect a change in the YCC target and expect the BOJ to reiterate its faith in this policy.
On July 6, President Trump imposed a 25% tariff on $34 billion of Chinese exports to the US and threatened to impose a 10% tariff on another $200 billion worth of exports, if China retaliated. China shrugged off this threat and last week imposed a 25% tariff on the same value of US products— mainly agricultural products such as soybeans, cotton, beef, pork, dairy, and nuts. This week Trump indicated that he was willing to put tariffs on all $505 billion of goods the US imports from China. You’d think that risk assets would have reacted badly to this tit-for-tat trade spat. Not really. In fact, July has been a great month for risk assets. The S&P 500 index (SPX) is up +3.75% this month and continues the uptrend off the early April lows with a series of higher highs and higher lows (see graph below) as Q2 earnings have come in thick and fast, with the majority of them either meeting expectations or surprising to the upside.
S&P 500 index: Performance 2018 YTD
Of course, the effect of US tariffs on steel and aluminium, which came into effect on June 1, is showing up as well. Alcoa reported its Q2 earnings last week and it indicated that the recently enacted US tariffs on steel and aluminium are hurting its earnings. Only 14% of Alcoa’s global aluminium output is produced in the US. The rest is imported. The stock promptly fell -13% as the market started pricing the hit to Alcoa’s earnings from more expensive imports. General Motors (GM) reported Q2 earnings yesterday and while the net income rose the stock fell -7% on the unexpected high raw-material costs in the wake of US tariffs.
As I mentioned earlier, while imposing tariffs may be Trump’s objective of returning America to its mercantilist past, the success of this policy will depend on the price American consumers are willing to pay. Tariffs on the scale of $505 billion, would inevitably lead to chaos and price rises for everyday products in the US and the retaliation that would follow would hurt the US economy and US businesses. Regular readers of this newsletter will know that I do not believe Trump will sacrifice the US economy and go for an all-out trade assault on China, the US’s biggest and most important single nation trading partner. Wages in America are not rising fast enough and are growing at an annual rate of +2.7%. A tariff of 10% on everyday goods? Trump will have to be careful to not impact US consumers too adversely, if he wants to keep playing Marshall Will Kane in the movie High Noon out to save a town.
Trump’s protectionist bark is likely bigger than his bite, particularly with respect to the US trading relationship with China. The US is on target to run a $1 trillion budget deficit by 2020 and the national debt is heading to over +100% of GDP. The US can ill-afford the extent of deficit spending it would need in case of a full-on trade war with China without adversely and terminally affecting its future prosperity. I, therefore, continue to be overweight US equities, with a preference for Healthcare (XLV), Financials (XLF) and Technology (XLK) stocks.
Despite the “deal” that Trump and Jean-Claude Juncker, President of the European Commission, announced last night, I am wary of European equities. First of all, it’s not a “deal” but a start of a negotiation to get a “tariff-free” deal and to get rid of all “trade barriers and subsidies.” Secondly, there’s no timetable for progress and that is troubling given how long it takes for the European Union (EU) to negotiate even a simple trade deal. Third, have you ever seen a La Poste or a Gendarmerie car which was not a Renault, Citroen or Peugeot? I haven’t in over a decade of my travels to France. Protectionist France doesn’t have a trade imbalance with the US. Why then would President Emmanuel Macron of France agree to remove all “tariffs, barriers and subsidies” and open the French market to competition and pick a fight with the powerful trade unions in France? His closet is already full of troubles and his popularity is sinking like a lead balloon. Finally, to understand Trump’s motivation to slap a tariff on autos you have to understand the US auto market and what it means for Trump and the US rust-belt economies.
The US auto market recorded annual sales of 17 million vehicles in 2017, of which just 4 million were produced in the US. Trump wants the US to stop importing 13 million vehicles each year and force its manufacturers to produce them in America, creating manufacturing jobs in the hollowed out American rust-belt. In that, Trump is taking a lesson from China which imports less than 1.5 million of its annual 28 million auto sales. Therefore, I will believe an EU-US “free trade” deal on autos and other industrial products when I see it. With crucial mid-term elections ahead, Trump only wants cover for his attacks on China that have brought about the tariff on US agriculture exports to China. To alleviate the pain inflicted by that tariffs on US farmers, Trump had to announce a $12 billion subsidy this week. Europe buying soybean and liquefied natural gas (LPG), at least until the mid-term elections, plays into Trump’s hand and he looks magnanimous as US farmers offload their soybeans in Europe. Post mid-term elections, he can beat up on the EU again, as public opinion will be behind Trump riding high on his mid-term success. I see this EU-US truce as temporary, and hostilities will renew post mid-term elections.
Emerging Markets have taken a beating thus far this year as the US Dollar strengthened. The MSCI Emerging Market ETF (EEM US) has underperformed the SPX by more than -10% and is due a catch up as sentiment improves and the USD rally halts. There is also the stimulus from China. At a meeting led by Premier Li Keqiang this week, the State Council, China’s cabinet, vowed to use more proactive fiscal policies to spur growth. I would however not recommend a long position in Chinese equities traded onshore, but instead would recommend the large cap Tech names that trade on US stock exchanges – Alibaba, Baidu, Tencent and JD.com. Semiconductor stocks such as Micron Technology (MU US) are another favourite of mine. China accounted for more than 50% of Micron’s revenue in fiscal 2017. The stock was hit hard due to fears of tariffs but that seems to be easing. The stock still trades at under five times forward earnings estimates and could double over the next 12-18 months.
As for Financials, which have had a bad run this year, the Q2 earnings came in strong with Q2 profits rising +16-20% year-over-year. Yet, bank stocks – JP Morgan, Bank of America and Citi – have not been well bid. This is a mistake. Results showed that demand for loans remains strong. The latest US Federal Reserve data, for the week ending May 2, shows total commerical and industrial loans outstanding up +3.1% from a year earlier, compared with +0.9% at the end of January. This is still lower than the robust growth of +10.6% and +6.5% in 2015 and 2016 respectively, but clearly way better than just+ 0.7% in 2017.
In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Pepsi (PEP US), LVMH (MC FP), General Electric (GE US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital
Society is a three-legged stool where each leg – economic, political and social – has to hold for the stool to stay upright. We often spend too much time and too many resources analysing and reporting on the economic and political legs, forgetting that the social leg is just as important, if not more so. Unaddressed, or wrongly addressed, social concerns have a tendency to creep up quietly and overwhelm societies – Brexit, Trump and the populist movement sweeping across Europe are good examples of this. German Chancellor Angela Merkel is finally in political trouble, not for economic mismanagement, but for her immigration policies. How fast the tide turns! When Merkel opened Germany’s borders to thousands of asylum seekers three summers ago, people in the affluent state of Bavaria rushed to help in such great numbers that authorities had to briefly turn back offers of clothing and food. It’s the same Bavaria now that has become Merkel’s Waterloo. The Christian Democrat Union (CDU) and the Christian Social Union (CSU) have formed a common group in the German Bundestag since 1949. However, this 70-year partnership that has provided leadership to the Eurozone over last two decades, is now at a breaking point. For the European Union (EU) and the Eurozone, the only thing worse than a strong Germany is a weak Germany. With the exit of Merkel, the EU would be robbed of the only political leader who appears to have the stature and experience to hold the bloc together, as it stumbles from one crisis to the next.
Italy, the beating heart of the European Union (EU) has gone from being a cheerleader of the Euro to a vociferous opponent. The market has taken note of a potential crisis brewing in Italy as a new populist government takes office. The yields on the Italian sovereign bonds (BTP) are rising and if you are looking to insure against a default, you will have to pay more to protect yourself against default on Italian bonds than Russian government bonds. That’s because, at €2.3 trillion, Italian sovereign debt is 132% of Italy’s GDP. Italy’s problems are lack of growth, shrinking industrial production and the absence of independent monetary policy levers to handle these. Since the peak of the financial crisis in 2008, Italy has lost over 9% of its GDP and a quarter of its industrial production. The average annual rate of growth per head in Italy, since the adoption of the Euro in 1999, has been zero. Therefore, an Italian born in 1999 who just turned 18 and has become eligible to vote for the first time, has seen nothing but economic stagnation during his lifetime. Yet, Italy is no Greece. Italy’s GDP at €1.7 trillion is ten times that of Greece. Italy runs a current account surplus, a healthy savings rate, and is a net contributor to the EU budget. Italy can not only survive outside of the Euro, it can thrive. The European Central Bank is nearing the technical and political limits of Quantitative Easing, and the growth in the Eurozone is slowing down. If yields keep rising and growth doesn’t pick up, it is likely Italy will relapse into an insolvency spiral. If Rome is then asked to submit to austerity for a second time, it will likely take matters into its own hands. The Euro experiment, therefore, may be nearing its end.
In the 1930s, for over eight and half years, the US ran a trade surplus. Presumably, had Donald Trump been US President at the time, it would have made him a very happy man. Or maybe not. The 1930s will be remembered for the Great Depression, the worst economic downturn in the history of the industrialized world. President Trump likes to blame “tariff barriers and unfair trade practices” for America’s trade deficit. However, the key issues that are prevalent in the US since the 1980s, are a high domestic consumption rate, a low savings rate and a low investment rate. America has a deficit because it consumes more than it produces and spends more than it earns, both privately and as a nation. The obsession that every country’s policymakers has with running a trade surplus ignores one basic reality: All governments cannot run a trade surplus. For every surplus, there has to be a deficit. For the sake of the US Dollar and the US itself, Trump should focus on the budget deficit and the national debt and not obsess excessively with the trade deficit. If the recent tax cuts fail to accelerate US growth, let alone reach +4% as Trump has suggested, the deficit will soar and make fiscal conditions worse. How long will foreign investors then continue to finance the US deficit? Every indebted economy has a day of reckoning. For the US the risk may not be immediate but it certainly is rising. It was debt that caused the UK and Sterling to lose their crown to the US and the Dollar. The enormous post-war balance of payments deficit was just too much for the UK. Debt had taken its toll.