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Brunello Rosa

15 February 2021

The recent rise in Eurozone inflation, from -0.3 y/y to +0.9% y/y in January 2021,has sent some shivers down investors’ backs, especially considering that inflation has also risen from +0.2% y/y in May 2020 to 1.4% y/y in January 2021 in the US. Mostly it is technical factors that are behind this rapid increase in inflation numbers: base effects kicking in after one year of pandemic, the recent rise in oil prices (partly driven by the economic rebound after the slump in economic activity experienced in 2020), the recalibration of the basket of goods and services being used to calculate inflation gauges, and in the case of Germany and the Eurozone the fading of the deflationary effect of the 2020 VAT cut that was taken to counter the worst effects of the pandemic. 

In spite of the recent increases, inflation remains definitely under control, well below the central banks’ targets, which are usually set around 2% in most developed markets. In the short term, some potential increases may derive from supply bottlenecks due to the disruption of global supply and value chains, which can reduce the availability of goods and services. The pandemic has shown that although these supply and value chains were very long and efficient during the merry years of globalisation, they are also very fragile. 

So, the main reasons behind a potential increase in inflation in the short run may be technical factors and supply shortages. To observe a more persistent rise in inflation we would need to wait for the closure of the largely negative output gaps that exist around the world, when economic activity returns towards potential and unemployment rates approach the non-accelerating inflation rate of unemployment (NAIRU). We do not expect this normalisation in economic activity to occur before H2 2021 at the earliest, with 2022 and 2023 more likely candidates. 

Even then, the “new normal” in economic activity may be very different from the era that preceded it. Jobs will be even more precarious than they were pre-crisis; the gig economy may become the new paradigm for an entire generation; the bargaining power of unions will be virtually zero for years to come. Hence, the possibility of strong, persistent, domestically-generated inflation will be limited in any case.

Considering this, how will central banks react? The vast majority of central banks in both DMs and EMs will likely look past temporary inflation spikes, especially if they are easily explained by technical factors. They can certainly tolerate transient increases in inflation due to short-term shortages of supply, so long as the output gap remains largely negative. They may be less tolerant towards a rise in inflation if the output gap is closing (even if that inflation is generated by technical factors or supply shocks), as a closing output gap may feed into inflation expectations. They will definitely be very vigilant against domestically-generated, demand-driven inflation deriving from the closure of the output gap and from unemployment rates reaching the NAIRU. 

Even in those circumstances, however, the reaction of central banks is likely to be moderate, at least to begin with. The adoption of formal or informal versions of Average Inflation Targeting (AIT) regimes will dictate that banks keep their monetary policy stance looser than they otherwise would, so as to recoup some of the price level lost during the years of inflation overshooting target levels. 

In any case, inflation is the variable to watch in coming years, given the impacts it could have on asset prices. A rapid rise in inflation will likely dent the valuation of all major asset classes, and will certainly hurt bonds (both sovereign and corporate), and most likely equities as well (via their dividend discount models of valuation) if central banks are expected to normalise their policy stances sooner than they otherwise would.

Even assets that are traditionally considered to be inflation hedges, such as gold, may need to prove their resilience in the event of rising inflation. Certainly crypto-assets will have to prove that they really are a good inflation hedge, even if these days they are highly sought after given mounting inflation concerns. Indeed, inflation may be the one variable that could transform the expected “roaring twenties” into the “moaning twenties” – if investors are disappointed by asset prices.

by Brunello Rosa

8 February 2021

At the beginning of last week, Italy’s President Sergio Mattarella shocked the Italian political system by announcing that he will confer the charge of forming the government upon Mario Draghi, one of the most well-known public figures at the international level. Mario Draghi has been President of the European Central Bank, inaugural Chair of the Financial Stability Board, Governor of Bank of Italy and Director General at the Italian Treasury. This career in public service has been briefly interrupted by a significant stint between 2002 and 2005 at Goldman Sachs, as Vice Chairman and Managing Director and member of the Executive Committee. 

Mario Draghi is mostly known, internationally, for his pronouncement “whatever it takes” , when he promised in July 2012 in London that the ECB will do anything to preserve the integrity of the Euro. These few words anticipated the introduction of the Outright Monetary Transactions (OMTs), i.e. potentially unlimited purchases of bonds of countries subject to idiosyncratic speculative attacks. Between 2014 and 2015 he managed to introduce negative policy rates and even direct purchases of public and private assets, the so-called Quantitative Easing, in the conservative setting of the ECB, a Frankfurt-based institution still dominated by the Bundesbank monetarist approach. 

By making those moves, Draghi was internationally praised for having “saved the euro” from what technically was called “redenomination risk”, but what in reality would have been a catastrophic collapse of the single currency and – with it – of the entire European integration project. 

Now Draghi has been called upon to save the European project from another danger. Because of the pandemic, Italy (the first country to be hit by Covid-19) has lost almost 10% of GDP in 2020, its public deficit has exploded to 10% of GDP and its debt/GDP ratio skyrocketed to almost 160%, only a tad below Greece in the Eurozone. As the pandemic hit other European countries, it became evident that Covid was not a idiosyncratic shock to Italy, but rather a systemic shock that – once again – threatened the survival of the EU.

After many months of negotiations, EU leaders finally agreed an economic rescue plan in July 2020, the so-called Next Generation EU plan, which contains the crucial Recovery and Resilience Facility (RRF). The Next Generation EU plan is the legacy that Germany’s Chancellor Angela Merkel wanted to leave to the next generation of EU leaders, a plan to make the EU more resilient, just, environmentally sustainable and digitalised. It was also an extreme exercise of solidarity from the countries “of the North” (Germany, Netherlands, Finland, Sweden, etc.) to the countries “of the South” (Italy, Spain, etc.) at the time in which most of the latter needed it. 

Now it is obvious that if this exercise of solidarity were to fail because the southern countries (chiefly Italy) prove not to be able to spend the funds coming from Europe efficiently and effectively, while accompanying them with a plan of reforms, the entire edifice of European solidarity would be badly shaken, with the risk of collapse of the integration process existing again over the next few years. Draghi’s job in Italy will need to show that the country as a whole is able to devise a plan of investment and reform that would make Italy ready for the challenges of the future. For him, the biggest challenge will be convincing a highly divided and reluctant parliament to vote for such a plan of reform to re-launch the country, however painful that may be. 

by Brunello Rosa

1 February 2021

Last week, media attention was attracted by the epic fight between day traders and the giants of Wall Street. That story is largely known now. Thousands of retail investors, organising themselves on platforms such Reddit and trading on online exchanges such as Robin Hood, have been purchasing the shares of the moribund company GameStop (considered a sort of “Blockbuster” for gaming), a company that funds such as Melvin Capital, which specialises in equity long/short strategies, had been heavily shorting in previous months. 

With the price of the stock rising from $17 per share on January 4th to $347 on January 27th, those funds were scrambling to purchase the stocks they needed to cover their short position. But the extent of the bet was such that those shares did not exist, resulting in their prices being pushed up at the speed of light. Eventually, regulators such as the SEC decided to intervene, to calm a market dynamic that was becoming uncontrollable, with retail investors prevailing against hedge funds and Melvin Capital closing its short position and needing to be rescued by its competitors. As the theory says, to be successful a speculative attack needs coordination among the agents involved in it, and a coordinated signal that suggests when the attack should start. The Reddit community had both. 

Taking sides in an issue of this sort is hard. One could feel sympathy for the market Lilliputians revolting against the giants of Wall Street, and especially the millennials behind this movement. Nevertheless, the coordination of actions in this way is dangerously close to market manipulation. Hedge funds do not attract popular sympathy, especially hedge funds that short the equities of struggling companies and so can result in the bankruptcy of businesses that might have otherwise survived. But this very strategy – shorting – is also the one instrument that market participants have to signal inefficiencies in the management or unviability of business models. 

As for the regulators, they are supposed to be the guardians of the market but tend to act too late, when the damage has already been done. Often, during severe market corrections, some regulators also ban short selling altogether, leaving the impression that market forces should be left free to act only if they push market prices up (the so-called Bernanke Put – now the Powell put). 

In the end, it does not really matter who is the good guy in this story, and who is the felon. The real question is what this episode signals, and what the lessons are that must be learnt. It seems to us that this “Reddit army” is following the tradition of fight-the-system/anti-globalisation movements that started with the Seattle WTO protests at the end of the 1990s(remember Naomi Klein’s “No Logo”?) and continued with protests such as Occupy Wall Street.  

One could even claim that the entire crypto-asset movement (net of its abundant scams, illegal activities and manipulation) was originally a way to disrupt “the System”. 

So, there is a fil rouge that connects all these protest movements in their “rage against the machine”, represented in dystopian movies such as The Matrix franchise. But one needs to be careful here. History teaches us that most revolts and revolutions aimed at democratising the system end up with autocratic regimes or even ferocious dictatorships. Even the mother of all revolutions, the French Revolution of 1789, ended up with Napoleon’s empire and eventually the “restoration” of the Congress of Vienna. 

The revolutions of 1848 (the year in which the Manifesto of the Communist Party by Karl Marx was published), which led to the temporary fall of many absolutist monarchies in Europe, similarly ended up with the election of Napoleon III to become the President of France. He too later became Emperor and an absolutist ruler. On a much smaller scale, the anti-globalisation sentiment prevailing among the middle- and low-income classes in the United States was eventually channelled by a plutocrat from New York: Donald Trump.

The lessons to learn here seem to be the following: 

1) Social malaise due to the restriction and loss of job opportunities induced by the pandemic is leading people to find other sources of income perceived as rapid and safe, such as day stock trading. 

2) Central bank liquidity, issued to help banks survive and sovereigns monetise public debts, is making one-way bets too widespread in the markets, thanks to the perceived “Bernanke put”.

3) The financial system seems more de-anchored from economic fundamentals than ever, increasing the chances of all sorts of distortions and manipulations occurring, which can end in devastating market crashes. 

4) The revolt of the people by way of coordination through electronic platforms is a signal of the underlying social malaise that, though exacerbated by the pandemic, originated decades ago with the decoupling of salary and productivity growth and the beginning the globalisation process. 

5) These events are further confirmation that politics, markets and geopolitics these days are taking place first and foremost within cyber space. Politicians around the world should take note of these events, if they do not want to see this revolt exiting the computer screens and taking to the streets. 

by Brunello Rosa

25 January 2021

The Covid-19 pandemic has now entered its second year, and its second wave that began in the autumn is now mixing with the expected third wave, which was forecast to peak in the spring of 2021 (following the example of the Spanish flu of 1918-19). The vaccination campaign has started, but the recent delays experienced in Europe in particular mean that heard immunity may not be reached before the autumn of 2021, at the earliest. 

After a year of the pandemic, we are now in a position to start evaluating the effectiveness of the overall policy response that has been employed against it. By way of comparison, during the Global Financial Crisis, which originated with a banking crisis in 2007-2009, the policy response was initially inadequate, as the policy arsenal available at the time was incomplete, and even the theoretical framework employed by policymakers was shaky at best. The knee-jerk reaction by public authorities at the time consisted of the nationalisation of troubled lenders, unlimited liquidity provisions and timid cuts in the policy rates by central banks. Only later in the process did central banks develop their full arsenal of tools, consisting of zero or negative rate policies, purchases of public and private assets, forward guidance on policy rates, asset purchases and reinvestment policies, and credit easing through the introduction of funding-for-lending schemes. 

It took years for many governments to realise that fiscal policy had to be part of the policy mix as well, and that a level of government coordination with monetary policy would not imply fiscal dominance. It took even longer to develop macro-prudential instruments to control financial imbalances in the economy and adopt smarter ways of stabilising troubled financial institutions than simply using taxpayer money (which later fuelled anti-establishment movements and populism). 

Because of the lessons learned from the Global Financial Crisis (GFC), at the beginning of the current pandemic the economic policy response was quick, adequate and effective.  

Central banks immediately reactivated their entire arsenal of policy tools, plus some additional innovations (for example the Reserve Bank of Australia’s yield curve control at the shorter end of the curve, to reinforce forward guidance).   

Governments meanwhile realised that ideology-driven fiscal budget constraints could not be accepted in a pandemic, and so launched large fiscal stimulus packages that drove deficits and debt into territories generally seen during wartime. Banks were little affected by the shock, as they had become more resilient after the GFC.

The economic policy response was, therefore, adequate for the most part, and has been partially effective in alleviating the worst impacts of the pandemic. The healthcareresponse was, however, suboptimal, especially in Western countries. In China, where the pandemic originated, the overall healthcare response was more forceful (in part, thanks to reduced sensitivity to citizens’ privacy as well as social rights by the government), and, as a result, more effective. In Western countries, the policy responses were more erratic and less effective. Vaccination campaigns started much later in Western countries than in China and Russia; though, of course, that may have been largely because the vaccine trials followed standards that were probably more accurate. 

Still, the concern remains that, as during the GFC, the initial policy response has been too conservative, and driven by questionable metrics. The measures that have been adopted, such as social distancing and lockdowns, derive from the medieval age. Policymakers have adopted the minimisation of deaths as the objective function, as opposed to considering it a constraint for the maximisation of true objective function, which is social welfare across the spectrum of social, economic and age groups. This conservative approach has resulted in disastrous repeated lockdowns, which will likely have massive long-term social and economic consequences that will be hard to manage once the pandemic emergency is over. 

As happened after the GFC, it will take years to realise what the best policy mix would have been. And, when this realisation finally happens, it will probably already be too late.  

by Brunello Rosa

18 January 2021

In our recent column, we noted how political risk was on the rise at the beginning of the year. This week will prove particularly challenging in this regard. 

In the US, the inauguration of the 46th  president in US history on January 20th, rather than merely featuring a speech by the new “leader of the free world”, as usually takes place, will instead be a highly risky event, with the state of emergency still in place after the “insurrection” that occurred on January 6th, when Donald Trump supporters entered the US Congress to stop the parliamentary ratification of the electoral college vote. The FBI warned that there may be armed protests in 50 states planned on the day of the inauguration, organised by far-right movements. To make things worse, the incumbent president said he will not attend the inauguration ceremony, thus opening a wound in the transition of power in the world’s leading democracy. 

In Europe, Italy is staging yet another government crisis. As is typical when centre-left governments are in power, a component of the majority detached itself in a sign of disapproval over the management of the pandemic and the process followed by the government in drafting the recovery and resilience national plan. Similar episodes occurred in 1998 when Rifondazione Comunista left Prodi’s first government, and in 2008, when UDEUR left the second Prodi government. The centre-right found itself in a similar situation in 2010 when Fini’s component of the Popolo della Liberta’ left Berlusconi’s fourth government. On that occasion, the government managed to survive a confidence vote by parliament thanks to a group of MPs (the so-called “Responsabili”) coming from opposition parties which joined the majority. 

As we discuss in our in-depth scenario analysis, we believe that Giuseppe Conte is tempted to follow this example of the centre-right, by trying to find support in a group of MPs coming from the current opposition (or, from Italia Viva, Matteo Renzi’s party that has been part of Conte’s governing coalition until now). 

But this is proving harder than anticipated. At this stage, a new government with “Responsabili” coming from opposition parties, or a new pact with Italia Viva, seem the likeliest scenarios. Elections seem the least likely outcome, yet cannot be completely ruled out.   

In Germany, Armin Laschet, currently the president of North-Rhine Westphalia, Germany’s most populous state, was elected to succeed Annegret Kramp-Karrenbauer as Chair of the CDU and, therefore, become the frontrunner to be the next Chancellor when general elections are held in September 2021. We anticipated the potential election of Laschet in May 2018, when he was totally out of the political radar screen. Laschet is a continuity candidate, so very reassuring in this respect, and he could easily lead a new centre-right coalition, or a new grand coalition with the SPD or the Greens after the elections. 

He may yet be challenged in his race to the become CDU/CSU candidate for the Chancellorship by Jens Spahn, the health minister whose effective management during Covid has boosted his profile at the national level, or by Markus Söder, the popular leader of the CDU’s Bavarian sister-party. In our view, as we discussed in an in-depth analysis of German politics, the main political weakness of Laschet is that he might leave the right flank of the party uncovered, as compared to Fredrik Merz. That political space on the right that may then be occupied by the AfD, thus posing risks to the Germany’s leadership in the European integration process. 

Last but not least, in the Netherlands, PM Mark Rutte and his cabinet resigned last weekin response to a child welfare fraud scandal. Rutte will, however, remain in office until the March 2021 general election, in which he hopes to be confirmed as party leader and Prime Minister. The election in the Netherlands has been one of the main reasons behind the slow ratification process by national parliaments of the Next Generation EU recovery plan. This delay poses a serious threat to the actual implementation of the plan.

by Brunello Rosa

11 January 2021

While new, more infectious, but so far not more deadly variants of Covid-19 are being discovered in many countries across the globe – for example in the UK, the USand South Africa – anti-Covid vaccines are being rolled out to limit the virus’ spread. The Pfizer-BioNTech, Moderna and AstraZeneca products have started being distributed in many countries, and vaccination campaigns will be carried out for months to come. 

A number of countries are adopting more severe restrictions to movement and social interactions in the meantime, by imposing new lockdowns. Germany has just extended its lockdown until the end of the month. The UK has launched its third full lockdown in nine months, and Spain is doing similarly. There is hope that after a third wave of the pandemic in the first few months of 2021, and an initial adjustment period to the vaccine rollout, the worst part of the crisis might end by June and, gradually, the pandemic may be overcome as we approach the end of 2021. 

While we are still in the middle of the battle, it may be hard to think about what comes after the pandemic is over. But this is an effort that we need to start making. We have already discussed how we think that the geopolitical ranking of countries will change after the pandemic, most notably with the US losing ground in favour of China. The latest episodes in Washington, with rioters entering and devastating Capitol Hill while Senators and Representatives were certifying the results of the electoral college that voted Joe Biden as the 46th US President, will damage the image of the US democracy for a long time, especially if one thinks that Trump might try to run for President again in four years.

In a previous column, we reminded readers how, after the 1918-19 pandemic and WW1, the fascist party was born in Italy, and totalitarian leaders emerged subsequently in various parts of Europe. Some analysts are making a comparison between the rise of fascism and the events in Washington on the 6th of January.    

But there will be more far-reaching consequences still. Social distancing and quarantines are not novel inventions: they have been the defense of humanity against pandemics for centuries. Their effects have been felt for decades after the end of their respective crises. For example, a parallel has been recently drawn between the roaring Twenties of the twentieth century, which begun after the end of the Spanish flu pandemic of 1918-19, and the situation that will exist a year or so from today. Various analysts wonder what will happen after the harsh restrictions on people’s movement are finally lifted. 

On the one hand, there is a theory that some of the limitations on people’s movement will remain for a long period of time even after the pandemic ends, inducing safer behaviour in society at large, with less travel, endless commuting, and extravagant social interaction taking place than was the norm before 2020. Opposite theories exist however, which suggest that once limitations will be lifted people will over-compensate by engaging in even more extreme social interaction, at the limits of debauchery even, lifted by over-excited animal spirits. 

In reality, a combination of these two scenarios may eventually emerge: more social control via digital platforms, more authoritarianism able to impose limitations on people's movement, but also more extreme forms of social interaction, especially in private life, to compensate for the reduced social and political freedom and limited economic opportunity that has been experienced this past year.

by Brunello Rosa

4 January 2021

In our global outlook published at the end 2020, we argued that 2021 will be a volatile macroeconomic and geopolitical year. From a purely macroeconomic perspective, if the anti-Covid restrictions in place in 2021 are milder than those put in place for 2020, the global economy should experience a rebound that could see it grow by 4% (according to our central scenario). This means that, following a 5% contraction in 2020, by the end of this year economic activity might still be at a level lower than it was at the end of 2019. There are significant upside and downside risks to this central scenario, and the unfolding of events directly and indirectly related to the evolution of the pandemic will likely lead to a volatile 2021 from a macroeconomic perspective. 

Geopolitics will be volatile as well. 2020 started with the killing of Quasem Suleimani, the head of Iran’s Islamic Revolutionary Guard Corps, by the US, and ended with the assassination of Mohsen Fakhrizadeh, the father of Iran’s nuclear programme, presumably by Israel. There are fears of renewed tensions between the US, Israel and Iran occurring on the anniversary of the assassination of Suleimani on January 3rd. 

The US and Israel will themselves be at the centre of heightened political risks in the next few days and weeks. In the US, this week will be crucial, given the runoff election for the two Senatorial seats in Georgia. As discussed in our report, if these seats were to be won by the Republicans (currently the baseline scenario), there might be a last attempt by the Republican party in the Senate to block the ratification of the results of the Electoral College for the election of Joe Biden as 46th President of the United States, which is scheduled to take place January 6th. If this were to happen, we could witness the beginning of a serious constitutional crisis, which could end up in the Supreme Court. 

Even if that fails, a Senate in the hands of the Republicans mean that Biden’s presidency will be held hostage to Mitch McConnell’s delaying practices.  

If the Democrats win both seats (currently a risk scenario), the 50-50 count in the Senate would give Kamala Harris the decisive say in many crucial votes, including in confirmation hearings for cabinet ministers. At that point Biden may become hostage to the leftist component of the Democratic party, which would push him to spend large amounts of money to fund infrastructure projects and fiscal stimuli. Between these two risks, perhaps paradoxically the traditionally moderate and centrist Biden may actually prefer being hostage to McConnell’s practices, rather than to those of his own party’s left wing. 

Israel meanwhile will hold another general election on March 23rd, its fourth in two years. These frequent elections are a sign that Israel’s political system remains highly fragmented and ineffective. The formal reason for the collapse of Benjamin Netanyahu’s government was the refusal by the prime minister to pass a budget that would cover 2020 and 2021, as demanded by the leader of the Likud’s coalition partner Benny Gantz, who was supposed to take over from Netanyahu in November 2021 according to the agreements made at the time the current government was formed in May 2020. Netanyahu’s intention in holding another election in March is to avoid having to give up his job to Gantz. 

In Europe, Italy is about to start a period of political instability which might eventually lead to general elections in the spring (an unlikely outcome at this stage), if a compromise for a new government, or a new version of the current government, is not reached between the parties supporting Giuseppe Conte in parliament. In fact, press reports suggest that by the 7th of January, Matteo Renzi might withdraw Italia Viva’s delegation from government, thus formally opening the political crisis, whose final outcome is yet unknown. 

by Brunello Rosa

28 December  2020

Just hours before Christmas, the UK and EU Brexit delegations announced that they reached an agreement which will prevent the most catastrophic effects of a no-deal Brexit from materialising. The agreement, reportedly in thousand pages of legal text, will regulate some of the most contentious issues, including: 

Tariffs and Quotas: most of the deal is centred around eliminating tariffs and quotas on goods crossing the borders between the UK and the EU. The UK had a goods import deficit of GBP 79bn with the EU in 2019.  

Financial Services: The deal mostly regards goods, and very little is said about financial services, and services in general, even as they still represent 80% of the UK economy and the UK has a GBP 18bn export surplus in services to the EU in 2019. The debate on “equivalence” will continue for years and so will the negotiations around it. 

Level Playing Field and State Aid: The UK and the EU will maintain common standards on workers’ rights, and on social and environmental regulations. The UK will adhere to common principles on state aid. 

Dispute Resolution and the Role of the European Court of Justice (ECJ): If either the UK or the EU departs significantly from common standards existing on 31 December 2020, resulting in a negative impact on to other side, a dispute mechanism will ensue, which could lead to tariffs being imposed on imported goods. The EU lost the battle to have the ECJ police the governance of the deal. The ECJ will continue to exert its authority over Northern Ireland, given the special status deriving from the Brexit withdrawal agreement.

Data and Security: The EU has the most advanced regulation of data protection on the planet (the so-called GDPR directive), and has not yet recognized the UK’s data protection regulation as being “equivalent.” For the time being, there will be a transition period of four months, in which data will continue to flow freely between the two sides of the English Channel. Regarding security matters, the exchange of information will not occur “in real time” as it has supposed to have done until now. 

Fishing: for some reason, this relatively unimportant issue became politicised. The agreement states that the value of the fish caught by the EU in UK waters will be cut by 25% with a phasing in period of five and a half years. Once the transition period is over, the UK will have full control of the access to its waters, and could make much larger cuts to the value of fish the EU catches within them.

So, regarding this last-minute agreement in its entirety, should we view the glass as half full or half empty? In our opinion it is half full. As we discussed in our preview (in which we predicted a skinny deal to be reached by the end of the year, without further delays), the risk existed that a no-deal Brexit would materialise, as the UK government might have masked the negative effects of a no-deal Brexit behind the Covid disaster. It is therefore especially good news that the more catastrophic consequences of a no-deal Brexit have been prevented. 

However, clearly a number of issues remain unresolved. First and foremost is the issue of financial services, which is the most notable absentee in the deal. Also, data sharing and protection as well as the issue of “regulatory divergence,” which remains the real “holy grail” of Brexit, remain to be finalised in coming months and years. The UK will have some manoeuvring space to diverge in coming years, but maybe not as much as it would have liked. 

In the end, the Brexit saga developed itself as we expected in terms of process and outcome. In terms of process, as we predicted at the very beginning of this saga, Brexit had similar dynamics to Grexit: referenda, multiple elections, changes in government, breaking points followed by temporary agreements. In terms of end result, stepping back a few years, the final outcome is very similar to what we predicted just over three years ago, in November 2017, when we said “Hard Brexit With Canada-Style FTA Is The Most Likely Outcome”. We were correct in predicting that (1) Brexit would eventually occur; (2) it would not be reversed by parliament or by another referendum; and (3) a grand bargain over the various aspects of the post-Brexit transition was unlikely to emerge at any point in time; and (4) the final outcome would be hard-Brexit with a skinny deal on some basic aspects. 

by Brunello Rosa

21 December 2020

Cyberspace has become just another dimension of our physical environment. The Covid-19 global pandemic, in forcing billions of people to limit their physical interactions, has shown how many activities can be moved to the cyberspace, including those that traditionally were aimed at increasing social networking, such as conferences and seminars. The global economy has become very much dependent on the well-functioning of cyberspace. At a time in which physical interaction is de-facto forbidden, a crash in the digital world would have severe economic and social repercussions. Yet last week one of the worst cyber-attacks in recent history was reported by many US federal agencies. Microsoft was also reported to be exposed to this attack. 

In geopolitics, the continuity between the cyberspace and the physical environment has become equally evident. Cyber-security has become the buzzword in this field; national security threats mostly come from technological developments. It is well known that the ban on 5G technology coming from Huawei and ZTE by the US and their allies was based on geo-strategic considerations. In this respect, the examples of Stuxnetand NotPetya are illuminating. Stuxnet, a computer worm directed against uranium-enriching centrifuges in Iran, has been considered the “world's first digital weapon.” The NotPetya attack against Merck and its clients and suppliers was, similarly, referred to as being akin to an “act of war.”

Following these developments, the concept of “Digital Sovereignty” has emerged. The contest over the ownership of data (the “oil” of the digital era) could lead to cyber-wars in the 21st century. Finding international rules in this very sensitive field is imperative if we want to keep a peaceful geopolitical environment, in cyberspace as well as in the tangible world. Most countries are developing their “cyber armies” to defend cyberspace, which has become in effect the fifth dimension in national security programs, together with land, sea, air and extra-terrestrial space.  

But technology is also a formidable enabler of positive developments for mankind. In our most recent FIN-TECH report, written along with Klecha & Co., we discuss how technology could be the vehicle to fast-tracking further European integration, for example. We discussed how one of the key goals of the Von Der Leyen Commission is to promote the digital transformation of EU countries. The new Recovery and Resilience Facility also requires that around a third of investments will be aimed at increasing the digitalisation of economic activities. And  the European Central Bank has just launched a report on the possible adoption of a digital euro as a way of accelerating the process of European banking union. 

In the geo-strategic arena, with the role of NATO coming under increasing scrutiny even in the US, the Europeans know that they will need to increase their military cooperation if they want to find a niche space in the developing Cold War between US and China. In this respect, the launch of the military Permanent Structured Cooperation (PESCO) among European countries and of the European cyber-security agency(ENISA) represent crucially important first steps. 

by Brunello Rosa

14 December 2020

As we discussed in our column last week, 2020 is ending with a number of issues unresolved. The second wave of the pandemic is raging across the globe, with the US registering the highest number of daily cases and deaths since the beginning of the crisis, Europe mired in its second round of severe restrictions (with Germany moving to a full lockdown that is set to last until January 10th), and a number of EMs still struggling to flatten their infection curves. 

Today, the US electoral college will finally elect the country’s 46th President, after the Supreme Court ruled against a lawsuit filed by Texas’ attorney general against Michigan, Georgia, Pennsylvania, and Wisconsin. However, alt-right supporters of Trump (including the so-called Proud Boys) gathered in Washington until yesterday to protest against the electoral result, suggesting that another four years of political tensions in the United States may underway. The EU, meanwhile, is getting closer to approving its multi-annual budget, but the implementation of the Recovery and Resilience Facility remains problematic. A no-deal Brexit looms large. As a result of these uncertainties, economic activity remains weak, and Q4 is likely to be another quarter of stagnation , or even contraction, with carry-over effects likely into Q1 2021. 

Given this background, policymakers know that monetary and fiscal stimulus is still very much needed to support aggregate demand and supply. Job-retention and salary-support schemes have been renewed anywhere. New rounds of fiscal stimuli are being planned globally. Even in the US, after the formal election of Joe Biden as president, the long-waited-for USD 1tn plan seems ready to be agreed upon. 

Through all this, central banks realised that they could not just sit on their hands. In the G10, a number of central banks have decided to provide another “shot” of monetary stimulus before the year ends. In November, the Reserve Bank of Australia cut rates to its alltime low, and begun formal QE; the Reserve Bank of New Zealand introduced a Funding For Lending Program ahead of a possible adoption of negative rates in 2021; the Bank of England (BoE) increased the size of QE by GBP 150bn (while keeping its powder dry in case of no-deal Brexit); the Riksbank increased and extended its QE program by SEK 200bn. So far, in December, the ECB increased the size of its PEPP program by EUR 500bn, while also further boosting its credit-easing facilities (TLTRO3 and PELTROs). 

This week, another four G10 central banks will hold policy meetings: the Federal Reserve (Fed), Norges Bank, the Bank of England, and the Bank of Japan (BoJ). The Fed is unlikely to add further monetary stimulus after the strategy review made it clear that the Fed will not increase rates and that QE will remain part of the “conventional” landscape for the foreseeable future. The BoJ has been happy to be on the back-seat of the policy response for some time, following years of audacious monetary experiments, including yield curve control. It will likely remain so in December, though it may announce an extension of its credit easing facilities. The BoE is not expected to do anything after last month’s surprisingly large package; not before knowing whether or not it will have to use its bazooka to stem the effects of a final breakdown in the Brexit negotiations with the EU. Norges Bank will likely keep its key policy rate unchanged at zero, and continue promising to keep it at that level for the foreseeable future. 

In any case, even with rates at zero, or negative, and all sorts of monetary instruments being put in place, G10 central banks will remain ready to intervene to support aggregate demand. Meanwhile they are working on their next big tool: their own digital currency (the Riksbank, PBoC and ECB are at the forefront of this trend), which will allow them to take policy rates deep into negative territory to fight the next systemic crisis – which hopefully will not manifest itself for many years yet. 

by Brunello Rosa

7 December 2020

As we approach the end of the year, many issues that have characterised 2020 remain unresolved, even if some of those issues may be inching towards being solved, or at least towards a stabilisation period. The most dramatic of these remains the Covid pandemic of course, with many European countries dealing with a severe second wave and the US registering the highest number of infections and deaths since the beginning of the crisis. The commercial and social restrictions imposed by countries to avoid the spread of the virus are pushing a number of economies to  the verge of a new contraction in Q4 2020, which could become another technical recession if these restrictions continue in Q1 2021. 

It is unclear as of yet when the most acute phase of the pandemic will end. A third wave is possible between January and March, and a number of central banks, including the ECB – the Governing Council of which meets this week – assume that there will not be significant stabilisation before June 2021, when the vaccination process of large segments of the population is expected to be underway. Regarding vaccines, some good news is emerging: in the UK, regulatory authorities have approved, in an emergency procedure, the diffusion of the Pfizer Covid-19 vaccine as of this week; EU authorities are waiting for further tests before giving the vaccine the green light. 

Having said all this, the real effectiveness of these vaccines will not be tested until applied to large parts of the population; in part, because the procedure (based on mRNA procedure) is highly innovative and experimental. In any case, as vaccines are applied and as more effective treatments are discovered, there should hopefully be better news regarding the pandemic by mid-2021.

Another open issue regards the result of the US presidential elections. Incumbent US President Donald Trump still refuses to concede victory to President-Elect Joe Biden, threatening to take the legal challenge to the Supreme Court. However little the chance of succeeding he has, clearly Trump’s refusal to concede is creating a wound to the US electoral (and therefore democratic) system. By law, all legal challenges should be settled at least six days before the electoral college meets. 

This year this happens on December 14th, so by December 8th all legal challenges are supposed to be settled – the so-called “safe-harbor deadline”. So, hopefully within the next few days the result of the US presidential election will be settled.   

However, the type of presidency that Biden will embark on may depend heavily on the run-off elections for the two senatorial seats in Georgia that will be held on January 5th. As discussed in our analysis, if the Democrats manage to win both of these run-offs, they will have fifty senators, which would give Vice-President Kamala Harris the deciding vote in the Senate. If the Republicans win at least one seat, then they will likely block a number of very important decisions by the Biden administration until at least the mid-term elections are held in 2022. 

Two other notable issues that remain open are Brexit and the approval and implementation of the Recovery and Resilience Facility (RRF) in the EU. Regarding Brexit, after yet another round of inconclusive talks, the two sides agreed to make a final attempt this week to see if some of the remaining issues on state aid, fisheries and regulatory divergence can be ironed out. We still expect a skinny agreement to emerge, in order to avoid at least the most catastrophic effects that would result from a no-deal Brexit. But, as the number of days remaining to December 31 shrinks, tensions in the negotiating process are set to increase.

Regarding the RRF, Poland and Hungary have applied a veto to its approval, which they intend to use so long as the link between the rule of law and the disbursement of funds remains part of the final agreement. Again, we still expect a final agreement to be reached, with sticks and carrots used to convince the two countries to remove their veto. But this means that the implementation phase will be at least delayed, and most likely will be a bumpier process than had initially been expected. 

Given all these uncertainties, which are weighing on economic sentiment and activity, policymakers have promised to keep the tap of monetary and fiscal stimulus open. As discussed in our latest Markets Review and Outlook, markets remain edgy and volatile, buffeted by the news on the uncertainties described above on the one hand, and the support provided by policymakers on the other.

by Brunello Rosa

30 November 2020

In mid-November, the member states of the Association of Southeast Asian Nations (ASEAN), together with Australia, China, Japan, South Korea and New Zealand signed the Regional Comprehensive Economic Partnership (RCEP) Agreement. The Agreement will improve market access with tariffs and quotas eliminated in over 65% of goods traded and make business predictable with common rules of origin and transparent regulations, upon entry into force. The RCEP is likely to be the one of the largest free trade agreements in history. It  will cover “a market of 2.2 billion people, with a combined size of US$26.2 trillion or 30% of the world’s GDP,” according to its signatories. 

Most importantly, the agreement signals that although globalisation may be not be in the greatest shape, it is not dead. It should not come as a surprise that the signing of the agreement came around two weeks after the US presidential election that have brought back an internationalist president such as Joe Biden to the White House. Biden was among the architects of the defunct Trans-Pacific Partnership (TPP), which was resurrected by Japan’s PM Shinzo Abe under the name of Comprehensive and Progressive Agreement for Trans-Pacific Partnership.

In fact, after four years in which the Trump administration has worked to demolish the international order created by Republican and Democratic presidents alike over the past few decades – pulling out the US of the Joint Comprehensive Plan of Action with Iran, the Paris agreement on climate change, the above-mentioned TPP, NAFTA with Mexico and Canada, the World Health Organization, and withdrawing US soldiers from the Middle East and Afghanistan and even from NATO member states such as Germany (to take just a few examples) – the new administration will likely try to reassert the US role in the world as being the cornerstone of globalisation.

This is happening at a time in which even a Conservative government in the UK, just about to pull out of the EU, is signing trade deals with Japan and Canada.  

As discussed in our recent report, while Biden will try to undo some of the damage made to the international position and reputation of the US by his predecessor (just as Trump tried to undo what he thought were the mistakes of the Obama administration), he would nevertheless be making a mistake if he simply tried to turn the clock back by a few years and ignore what has happened in the world in the meantime.

The backlash against globalisation has been real, even if represented by unlikely champions such the billionaire Trump. In France, the Gilet Jaunes protests has threatened a globalist leader such as Emmanuel Macron, while around the world autocratic and protectionist leaders have emerged. Biden will have to take into account the events of the last few years if he wants to succeed on the world stage of today. 

In any case, the Covid pandemic has balkanised the global supply and value chains, fostered protectionism and led to border closures. The damage caused to the global economy is immense, and its social consequences will be felt for years to come. It is impossible to think of an enduring recovery without a reopening of the economy and relaunching of international travel and trade. 

Globalisation has had plenty of flaws, and caused endless discontent, but it has managed to take hundreds of millions of people out of poverty, especially in Asia. That is a fact the newly signed RCEP agreement makes abundantly clear. 

by Brunello Rosa

23 November 2020

In July 2020, an agreement was made between EU leaders to approve the Next Generation EU (NGEU) rescue package to assist the recovery of economies that are being plagued by the pandemic and its socio-economic consequences. The agreement was saluted by some as Europe’s “Hamilton moment” (when US states’ debt were federalised). While we consider the agreement a historic step in the process of European integration, we never subscribed to the idea that NGEU represents the EU’s Hamilton moment. , at the very least because there is no “joint and several” guarantee by member states on the bonds issued by the Commission. 

Moreover, the amount of “federal” fiscal expenditure remains modest compared to national budgets and the overall EU GDP. In our analysis of the agreement, we also highlighted the risks to the ratification process, which requires each parliament of the 27 EU countries to approve the package (a unanimous process akin to a Treaty change). 

The implementation of the NGEU package, which includes the Recovery and Resilient Facility (RRF), is proving as hard as we expected it to be. Two countries, Hungary and Poland  (both of which are currently subject to the proceedings of Article 7 for the violation of basic EU values, such as the independence of the judiciary) blocked the adoption of the agreement, and also vetoed the Multiannual Financial Framework for the years 2021-27, unless the provisions of the agreement regarding the respect of the rule of law are removed or softened. The ratification process is likely to be bumpy in the Netherlands as well, given the upcoming general elections in the spring of 2021. We expect these hiccups to be overcome eventually, but the actual introduction of the package is likely to be postponed at best.

Additionally, it is taking time for countries to present their respective national recovery plans, on the basis of which EU funds will eventually be disbursed. Only 5 out of 27 countries have presented such plans, without which the RRF remains a theoretical exercise. Recently, the EU Commissioner for economic affairs, Paolo Gentiloni, encouraged countries to speed up the process of presenting those plans, by establishing emergency procedures. He was particularly explicit in the case of Italy, one of the largest beneficiaries of the NGEU in absolute terms (though less so as a percentage of its GDP).  

As we have highlighted in our analysis, the NGEU package would have never been approved in its current form if the UK had remained part of the EU. In 2015, the UK opted out of the establishment and use of the EFSM, the facility created to sort out the Greek – and subsequent Eurozone debt – crisis, the model from which the NGEU and RRF have been designed. 

Post-Brexit, the presence of the UK was not an obstacle to the approval of a package that further pushed the process of European integration. As we discussed in our recent publication, the UK and EU are approaching the endgame of the Brexit negotiations. We expect a skinny deal to emerge eventually, in order to avoid the most catastrophic consequences of a no-deal Brexit. 

Meanwhile, the UK has struck a deal in principle with Canada, rolling over the terms of the deal that Canada and the EU made in 2017. This follows the trade agreement the UK made with Japan. Both agreements get the UK closer to joining, or at least benefiting from, the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, i.e. what remained from TPP after the US pulled out of it. If Trump had won the US presidential election (and it is becoming increasingly unlikely that he will do so, as most of his lawsuits against Joe Biden’s victory are being rejected by judges), the UK might have struck an FTA with the US and used it to put pressure on the EU to compromise on Brexit. But now this solution is not at hand. Also, the UK could reach FTAs with Canada and Japan quickly only because they are based on the deals made by the EU with those countries in recent years, both made following years of negotiations. 

Given these circumstances, it is becoming increasingly clear that an agreement on Brexit between the UK and the EU is the most convenient option for both sides. 

by Brunello Rosa

16 November 2020

Last week, Pfizer reported initial results of the tests of its anti-Covid vaccine, exhibiting a 90% efficacy rate. The news sparked optimism among global investors, with equity markets rallying (MSCI was up 2.2% on the week). This occurred while a number of European countries started to enter national lockdowns (as we discussed last week), as the infection rates soared again, posing a risk that national health systems will be overwhelmed. This second round of lockdowns will have dramatic effects on societies and their economies. A double-dip recession has now become the baseline scenario for European economies, as Q4 is likely to be another quarter of negative growth. 

In the US, daily infection rates have reached 180,000, the highest level on record. Nonetheless, in spite of some localised restrictions, state governors are still reluctant to declare the total closure of economic activities. In this respect, the US presidential election might represent a slightly more positive direction being taken. With 306 votes in the electoral college, Joe Biden has won the presidential race. As we discussed in our in-depth analysis of the results, Donald Trump will try to launch a series of legal challenges to this outcome, but they are unlikely to succeed. 

With a 36-vote advantage in the electoral college, Joe Biden may afford to judicially lose a couple of relatively large states, and yet remain president elect. This means that, in spite of the short-term noise and the difficulty in the transition process, this huge element of political uncertainty has been removed for investors. A divided Congress (if the Senate remains, as it seems likely, controlled by the Republicans) means that the fiscal stimulus is likely to be smaller than would otherwise be the case had the Democrats won, but this means the Fed may be required to do a bit more.   

As we discuss in our “Brexit Endgame” preview, the Brexit saga is likely to enter its final crunch week. An agreed text needs to emerge at the end of the EU Summit on November 19 for a no-deal Brexit to be avoided on January 1st, 2021. A skinny FTA is likely to emerge this week or in coming days, as the government cannot conceal Brexit behind Covid anymore, as Covid has proved to be a national disaster anyway. 

Countervailing these events, a new round of monetary and fiscal stimulus is likely to be adopted by national governments and central banks. Central banks in particular are reacting. The ECB has already announced an expansion of its programs in December. The Bank of England (BoE) has approved a new increase in its APF facility by deliberating an increase of GBP 150bn in asset purchases until the end of 2021. The Reserve Bank of New Zealand (RBNZ) has launched a new credit-easing facility (a Funding For Lending Programme). Both the BoE and the RBNZ have contemplated the possibility of introducing negative policy rates, although the actual implementation of such a program may be postponed well into 2021. 

During all of this, equity markets have been continuing to make a timid comeback following the slump of early 2020, while remaining vulnerable to the series of corporate defaults that may follow the peak of the Covid-induced crisis. The only real winners seem to be the tech companies (well represented by NASDAQ), which can take advantage of the massive increase in digital application due to widespread lockdowns

by Brunello Rosa

9 November 2020

As we discussed in our recent publications, a number of countries, especially in Europe, have decided to enter a new phase of general lockdowns. France, for example, after adopting a curfew policy that proved ineffective, started to implement a general lockdown from October 30 to December 1st. Germany, which during the first phase of the pandemic witnessed an infection rate markedly lower than other countries (the result of more effective testing measures and a larger number of intensive care units) is also introducing a sort of semi-lockdown now, from November 2 to November 30. Italy is adopting a three-tiered restriction system which might easily morph into a national lockdown in coming days. The UK, which adopted a tiering system earlier on, switched to full lockdown on November 5, which for now is set to last until December 2nd. Other countries, such as Greece, Belgium and Spain, are adopting similar measures. 

These generalised lockdowns have been decided upon as the second wave of the pandemic hit following the reprieve that occurred during the summer (as we discussed in our recent column). Studies have shown that this second wave originated from a virus mutation that occurred in Spain during the summer. As Spain – together with France – decided to adopt an open-door policy during the summer holidays in order to save the tourism season, this mutated version of the virus has spread across Europe this autumn. Most governments seem to be flirting with the idea that a full lockdown in November will allow countries to reopen for Christmas, but this strategy seems self-defeating in the light of the Spanish example above: any sacrifices made during these weeks in November would likely be nullified by a reopening of shops and a restarting of domestic and international flights for the holiday season. 

The question is on what basis these new generalised closures were decided. Most governments got scared, and seemed frankly unprepared to this second wave, as the number of new cases soared in recent weeks (see map above). Some governments decided to adopt new lockdowns after a certain threshold of new daily cases was reached (a threshold that would purportedly translate into a relatively predictable percentage of hospitalisations, intubations and – eventually – deaths). 

But these metrics seem highly questionable. In a pandemic generated by an airborne virus, to reach “heard immunity” it is obvious that the number of cases will have to increase. Over a relatively short period of time, a vast proportion of the population will in theory have to get infected (even without necessarily being symptomatic) in order for herd immunity to be achieved. For the same reason, even the apparently more sophisticated metric of  the percentage of positive cases as a share of the overall number of tests (a metric which should control for the increase in the number of tests), appears to be wrong. Over time, as we reach heard immunity, that percentage will have to increase towards 70-80% without necessarily being a cause for alarm.

In that case, what metrics should actually be used? Well, first of all, in order to get a sense of the speed at which the virus is spreading, governments should compare the actual rate of infection with the theoretical rate of infection as calculated by epidemiologists.  

A natural progression of the virus’ spread should not lead to generalised closures of the economy, whereas a faster-than-expected spreading should prompt the adoption of increasingly severe restrictions. The second metrics should be based on the hospitalisation rate (and within it, the intubation rate), so as to make sure health systems are not overwhelmed. This is because the unfortunate statistic of Covid is that only 50% of those entering intensive care actually make it out alive (rendering intubation effectively a coin toss). But again, the solution to this problem is building more intensive care units (ICUs) and adopting more effective treatments, not adopting new lockdowns. Most governments did not increase their ICU capacity between the first and the second waves of the virus, in spite of the fact that the coming of the second wave was highly predictable.  

In fact, it seems anachronistic that social distancing, a medieval solution against pandemics, remains today the most effective way of stopping the virus, in the era of massive technological and medical advancement. The case of Donald Trump may serve as an example. He was hospitalised and then released within 3-4 days, after receiving innovative (indeed, almost experimental) cures, including a mix of remdesivir, an antiviral drug, with polyclonal anti-bodies and other substances. This example proves that an extremely effective treatment for the disease does exists, but is clearly not available to the vast majority of the population. 

Finding an effective cure might prove even more promising than developing a vaccine. The three most advanced products under trial (in phase three) won’t be ready before March 2021 at the earliest and won’t be available for the wider population before Q3-Q4 2021 at best.  Additionally, the effectiveness of these vaccines may prove elusive, if the virus mutates. Recently, the WHO has identified a new variant of the virus deriving from farmed minks in Denmark. If this new variant were to spread further, the vaccines currently under development may prove to be not very effective, and new vaccine trials may need to start from scratch. 

Clearly the solution to this pandemic must be a mix of social distancing, better treatments, and the development and usage of vaccines, with lockdowns being the extrema ratio. Perhaps the emphasis should now be put on treatments rather than vaccines, as countries needto reopen. Economies and societies cannot tolerate this “stop and go” approach, whereby total closures are followed by partial re-openings, for too long. The long-term economic, social and political consequences of such an approach could be devastating.  

Companies are now unable to plan and invest without any certainty about the near future, and workers are continuing to increase their levels of precautionary savings and are under-consuming out of the fear of  joblessness as a result of the pandemic. Mental illnesses are also becoming endemic, as a mix of fear, anxiety, and stress is faced by individuals around the globe. Entire sectors, for example the hospitality and transportation sectors, are on their knees and struggling to survive as their business  models simply cannot cope with pandemics. The political consequences of pandemics should never be under-estimated either. In 1919, Benito Mussolini formed the Fasci di Combattimento (the predecessor of the Fascist Party) not only immediately after World War 1, but also following the 1918-19 Spanish flu pandemic. It is not out of the question that political radicalisation could similarly follow Covid-19. 

by Brunello Rosa

2 November 2020

This week investors’ attention will be focused on the US presidential election, which will take place on November 3rd. In reality, as of Wednesday last week, 75 million people have already voted, either in person or by post. This represents around 54% of the total turnout recorded in 2016. So, it is quite likely that this year the turnout will be higher than in the last election, even if the number of people who will physically vote on Tuesday is lower than usual, as it probably will be due to the Coronavirus pandemic. 

As we discussed in our preview, the Covid-19 pandemic - its economic and social effects, and the way it was managed - will clearly represent a determining factor of the final outcome of the election. According to the latest statistics, the US, with its 9.2 million reported cases (out of 46.2 millions worldwide) and 230,000 deaths (out of 1.2 millions globally), has had a very unfavourable track record. Despite being just 4.3% of the world’s population, the US has had almost 20% of reported cases and deaths. This means that something has gone wrong in the way the pandemic was managed, or the way the US healthcare system is organised. We know both elements are true: President Trump’s management of the crisis has been erratic at best, and large parts of the population are still not covered by public or private healthcare. 

Having said that, the US is not alone in this crisis. A number of countries, especially in Europe, are facing the second wave of the pandemic after re-opening their economies during the summer. As a result, new total or partial lockdowns (of at least one month) have been carried out by Germany, France, and the UK, and likely will soon be by Italy as well. 

The economic impact of these new restrictions will be large, and therefore the V-shaped recovery that some policymakers were fantasising about will not materialise (as early as March we have been saying that such a recovery was unlikely to happen). A long, uneven, bumpy U- or W-shaped recovery will likely take place instead. 

 Given all this, central banks have re-started their engines of monetary easing to complement fiscal stimulus. Last week, the European Central Bank explicitly said that in December it will recalibrate all its instruments, the Bank of Japan reiterated that it stands ready to act, and the Bank of Canada began a sort of semi-twist in its asset purchases to increase the effectiveness of QE. This week, we expect the Bank of England and the Reserve Bank of Australia to actually deliver more monetary stimulus with a combination of increased asset purchases, rate cuts, enhanced forward guidance and additional credit easing. 

This is the climate in which the US election will take place. In our previous comments, we discussed the successes and the failures of Trump’s presidency. In our preview we discussed how we believe that election night will likely be followed by a nasty legal battle by Trump, who has been saying for months that the postal vote (which Democrat voters prefer) is rigged. He might be trying to claim victory after a possible advantage deriving from the in-person voting during election night, but for the US television networks it will be hard to declare the winner in each state with 50% of the votes still to be counted. The only way the result will not be severely contested is if Biden wins a large majority in the electoral college, something could happen if he were to win a large state such as Florida. 

Eventually, we still expect Biden to emerge as the final winner, perhaps even leading a “blue sweep”, with the Democrats taking control of the Senate as well. However, a word of caution is needed. As Michael Moore - the movie director who predicted Trump’s victory in 2016 - said, “Trump electors are always undercounted in polls.” A surprise victory by Trump cannot be ruled out.  

by Brunello Rosa

26 October 2020

Months ago, UK PM Boris Johnson said that unless an agreement between the UK and the EU was found by the October 15th EU Summit, both sides should start preparing for a “no deal” scenario at the end of the transition period on 31 December 2020. The EU Summit ended without such an agreement, and Johnson said that negotiations will be over unless the EU becomes ready for a “fundamental change” in perspective. In effect, the UK government has been repeatedly telling companies and individuals to prepare for a no-deal environment.

After a few more days of back-and-forth declarations from the two sides, negotiations have in fact re-started in London in “submarine mode”, i.e. with sherpas from the two sides aiming at preparing a joint text, without consulting with their political stakeholders and without briefing the press as to the level of progress they have made. At the end of this “tunnel phase” of the negotiations, a joint text agreed by the two sides may emerge. 

There are three main areas of contention here: fisheries, state aid and dynamic regulatory alignment. Regarding fisheries, the EU would want EU boats (mostly from France, Spain and Ireland) to continue fishing in British waters, whereas the UK wants exclusive access. Regarding state aid, the UK wants to be able to subsidise its industries, which will need to adjust(sometimes heavily) post Brexit, whereas the EU wants the UK government to follow EU rules that forbid countries (outside of the current Covid-19 emergency) to provide state aid to private companies, so as not to distort the existing “level playing field”. For the same reason, the EU wants the UK to continue aligning also in the future (i.e. “dynamically”) with EU regulations even after the end of the transition period, something the UK will resist as much as possible as it attempts to reap the benefits of Brexit. 

At the same time as these talks proceed, a number of other major events are occurring that could have an effect on the positions of Britain and the EU. In the US, the presidential race is entering its last phase ahead of the November 3rd vote. 

As discussed in our preview, we currently expect Joe Biden to win the race, even if perhaps after a nasty legal battle. If Biden wins, Johnson’s negotiating strategy might fail, as he needs the support of Donal Trump to show that the UK has a viable alternative to trading with the EU (however credible the threat of severing trade ties with Europe might actually be). 

Meanwhile the UK has managed to strike a trade deal with Japan, which – according to the UK government – will be able to “secure additional benefits beyond the EU-Japan trade deal, giving UK companies exporting to Japan a competitive advantage in a number of areas… The deal is also an important step towards joining the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).”

Given this background, the EU and the UK will now have to 

decide whether to make at least a “skinny deal” in order to avoid a cliff edge at the end of December, without which major disruptions could  possibly occur in the financial industry, in transportation and trade. Room for compromise exists: the UK can give in on fisheries and state aid in exchange for the freedom to diverge from the EU from a regulatory standpoint. Indeed, the UK will never be able to absorb all the fish available in its seas with its small domestic market, and has never been particularly keen on state aid since the Thatcher’s liberal revolution. 

At the same time, for Brexit to be a success, obtaining regulatory divergence over time (especially on new areas such as data collection, management and protection) is absolutely essential for the UK. The EU might accept this trade-off, as long as the UK does not become a de facto offshore financial centre and does not engage in savage regulatory competition. If such a compromise does eventually emerge, it will still be “hard Brexit,” but perhaps less hard than it otherwise could be. 

by Brunello Rosa

19 October 2020

As the second wave of the pandemic is in full swing, its economic impact is becoming increasingly evident. The rapid increase of new daily Covid cases in Europe, which have recently surpassed those of the US, is forcing a number of European countries to implement renewed restrictions, such as partial lockdowns, or tiered systems such as those adopted by the UK. If the experience of the Spanish flu is of any guidance, the world might even experience a third wave in spring 2021, before a combination of incipient herd immunity, better treatment and availability of vaccines finally manage to tame the pandemic in H2 2021.

As a result of a longer than expected pandemic and more restrictive measures, the economic impact of Covid-19 is likely to be larger and longer than initially estimated. 

According to the latest estimates of the IMF, although global growth should fall less this year than had been expected in June (by 4.4% in 2020, with a 0.8% upward revision) the rebound after that is also expected to be shallower (5.2% in 2021, vs the 5.4% that had been expected in June). So, the IMF too is getting closer to the idea that the recovery will be U-, rather than V-shaped. But we consider even these projections to be too optimistic. 

If that is the case, it means that policy support is likely be larger and more prolonged than had been initially envisioned. During the IMF meeting a message emerged clearly: fiscal stimulus needs to be at the forefront of the policy response, with monetary policy either complementing fiscal policy or – bluntly said – simply monetising the ballooning fiscal deficits and debts.   

In fact, according to the latest forecasts in the IMF’s fiscal monitor, the US will reach a deficit of 18.7% of GDP, the UK of 16.5%, and the euro area of 10.1% in 2020, with France 10.8% and Italy at 13%. In terms of gross public debt in percentage of GDP, the IMF estimates the US to reach 131.2% in 2020, the UK 108%, the Euro area 101.1, with France at 118.7% and Italy at 161.8%. 

As a result of these ballooning levels of public deficits and debts, rating agencies are starting to re-evaluate the sustainability of public finances, and starting to take action accordingly. During the last week end, Morningstar DBRS downgraded France from AAA to AA, with the outlook moved from negative to stable. Equally, Moody’s has downgraded the UK from Aa2 to Aa3, also changing the outlook from negative to stable. The downgrades of these solid sovereign issuers will have little market impact, especially because the respective interest rate curves in those countries remain historically low. But for other countries, rating actions might have a larger impact. 

For example, the Italian rating will be reviewed by S&P Global, DBRS and Moody’s between October 23rd and November 6th. After the recent downgrades of more solid sovereigns such as the UK and France, a downgrade of the Italian rating becomes more likely. However, Italy’s position is more precarious as the country is already at the bottom of the investment grade grid, being Baa3 for Moody’s, BBB for S&P, BBB- for Fitch and BBBh for DBRS. A downgrade by Moody’s and Fitch would make Italy one of the most significant “fallen angels” of this crisis. 

In terms of immediate impact, the effects of a potential downgrade have been partially softened by the ECB, which has already said that “fallen angels” will continue to be used as collateral in refinancing operations or in PELTROs. However, asset managers following indices may need to start rebalancing their portfolios as a result of a downgrade. All this is to say that Covid-19 not only can attack the human body in unexpected ways, but may have larger economic repercussions than was initially envisaged.

by Brunello Rosa

12 October 2020

This week, the annual meetings of the International Monetary Fund (IMF) and the World Bank will begin. Though large component of the scheduled events will take place virtually, the IMF will still be releasing the latest edition of its World Economic Outlook (WEO), which includes updated estimates of growth and inflation for the vast majority of the economies of the world. According to the Brookings – FT tracking index, the recovery will remain fragile and patchy. This is in line with the column we published on 28 September, titled “Covid’s Second Wave Threatens Economic Recovery and Market Stability.” 

This is also in line with our latest Global Outlook Update - Market Views - Q4-2020 Strategic Asset Allocation, titled “Volatility To Create Opportunities, While Investors Keep Focus On The Long Term”. In that report we discussed how the Covid pandemic was likely to come in at least two, if not three, waves, the same way the “Spanish flu” pandemic did in 1918-19. In our analysis, we discussed how the second wave was the most deadly of the three waves during that pandemic a century ago. Given the rise in cases registered globally in the last few weeks, it is clear we are at the beginning of the second wave of the current pandemic. We cannot rule out there being a third wave in the months ahead, if the vaccine is not found before Q1 2021 (as we assume in the baseline scenario of our Global Outlook Update). 

Our report also discusses how we expect global growth to be worse than had been estimated by the IMF in June (we expect -5.3% growth, vs the -4.9% the IMF estimated), with the rebound in 2021 more anaemic as well. As a result, monetary and fiscal accommodation will still be required. 

In terms of fiscal policy, most governments will continue to provide protection to companies and individuals, but,  as UK Chancellor of the Exchequer Rishi Sunak said in parliament at the end of September  governments will not be able to save every company and every job. In Europe, where the institutional setting remains more fragmented, the approval and implementation process of the Next Generation EU plan is now encountering some difficulties, which might delay the arrival of its funds further into 2021. 

For this reason, monetary policy needs to remain highly accommodative. Following the Fed’s de facto promise of keeping rates extremely low for a much longerperiod of time, all other central banks are reacting, both in developed and emerging markets. In the G10 sphere, we expect imminent moves (in November) from the Bank of England, the Reserve Bank of Australia and the Reserve Bank of New Zealand, featuring a combination of rates cuts, revised forward guidance, larger asset purchases and new credit-easing facilities. Negative policy rates have started to enter the radar screen of the central banks in the so-called Anglosphere (the US, UK, Canada, Australia, and New Zealand), which so far have been the most reluctant to adopt them. 

Through all of this, markets remain volatile, with equity markets having just experienced the second week of a rebound after four weeks of market losses. Meanwhile we are entering the most delicate part of the US electoral campaign, which could culminate in a 10% correction in equity markets in case of a highly contested result. In this volatile environment, strategic asset allocators should focus on longer-term investment horizon.  

Picture source: Taubenberger JK, MorensDM. 1918 Influenza: the Mother of All Pandemics. Emerg Infect Dis. 2006;12(1):15-22.

by Brunello Rosa

5 October 2020

Last week US President Donald Trump tested positive with the SARS-CoV-2 (Covid-19) infection, together with a number of members of his family, his inner circle and White House staff. Press reports suggest that he might have contracted the virus from his senior advisor Hope Hicks (former director of strategic communications at the White House) or, possibly, during what was defined as a “super-spreader” event, held at the White House on September 26th, just a few days before he tested positive. 

The first obvious concern is whether, how and when the US President will fully recover from the disease, for which he was hospitalised and treated with innovative (indeed, almost experimental) cures, including a mix of remdesivir, an antiviral drug, with polyclonal anti-bodies and other substances. In a recent message from the hospital, Trump declared himself to be in good shape and on his way to recovery. 

The second concern is what type of impact this event could have on the US Presidential race. Since the first debate between Trump and the Democratic nominee Joe Biden took place on September 29th, it is not impossible that Joe Biden also contracted the virus, possibly from Trump, Trump’s family, or his inner circle, members of which were not wearing a facemask at the debate. If both candidates were to have Covid, it is possible that at least one, if not both of the subsequent debates (currently scheduled for October 15th and October 22nd) will be cancelled. This would be a real novelty for US Presidential elections; the American public has been able to watch televised presidential debates since 1960. 

Another issue is that Trump’s infection might fundamentally alter his political strategy. Clearly, most of his bold communication was centred around his attempt to downplay the significance of the virus. 

This was an attitude that he shared with all of the other major Covid-sceptics, such as UK Prime Minister Boris Johnson and Brazil’s President Jair Bolsonaro, both of whom have also fallen ill with Coronavirus in the last few months.   

Having contracted the virus himself, and being hospitalised (in a military facility), it will be hard for Trump to continue downplaying the significance of the pandemic and its impact on public health, the economy and society in general. There have now been almost 210,000 cases directly attributed to Covidin the United States. 

Additionally, given Biden’s advantage in the polls, it was clear that Trump was getting ready for a nasty legal battle following the night of the vote on November 3rd. Trump thought the election result could reach the Supreme Court, as it did in 2000 in the contested election of George W. Bush and Al Gore. That partially explained the heist with which he appointed Amy Coney Barrett as his Supreme Court pick in substitution of the late Ruth Bader Ginsburg, who died on September 19th. If Trump (and – a fortiori – if both Trump and Biden) were still to be in hospital in November, would that strategy still pay off?

Finally, and most importantly, will Trump’s infection fundamentally alter the American voters’ perception of how Trump handled the pandemic? The obvious narrative from the Democrats would be that, the same way that Trump didn’t care for his own health (and his family’s and inner circle’s health), he was way too nonchalant on his approach to the pandemic for the country, ultimately allowing the virus to spread out of control and result in a death toll much higher than what would have been the case had he had adopted more stringent containment measures. 

The Republican response is likely to be based on Trump’s recovery: a fast and full recovery would be used as an argument to say that the significance of the virus and the pandemic is vastly over-stated. This would help Trump’s light-touch approach to appear be justified. The voters will ultimately decide whose narrative gets more traction. 

by Brunello Rosa

28 September 2020

In many countries in Europe, a second wave of Covid-19 infections is materialising. According to the European Centre for Disease Prevention and Control, recent developments in Spain, France and the UK seem to be particularly serious. Unlike during the first wave, Italy is less exposed this time. The 14-day cumulative number of Covid-19 cases for 100,000 inhabitants is 320 in Spain, 230 in France, 96 in the UK and 32 in Italy. For reference, the same figure is 30 for Germany, which has responded best to the epidemic among large countries in Europe. 

As the map above shows, in Spain the situation already seems to be close to critical, with Intensive-Care Units (ICUs) on their way of being filled up again like they had during the first wave from March to June. In France, the situation is also alarming, with large portions of the country reporting some of the highest infection rates in Europe. In these two cases, the recurrence of the virus seems to be connected to the relaxation of social distancing policies during the summer, which had been adopted to at least partially save the tourism season. 

In Italy, the rules have remained as stringent as they had been before (although people became more relaxed in implementing them, as was the case in Sardinia), but the severity of the initial lockdown seems to be having beneficial long-term effects. In the UK, the situation is also becoming increasingly critical, as the government openly incentivised people to return to work and go out for dinner, with the scheme Go Out To Help Out. 

The idea that the situation is more severe in the UK than in Germany and Italy because “British people love freedom,” as declared by UK PM Boring Johnson during his recent Question Time, is simply laughable. [Italy’s President Mattarella’s response that “also Italians love freedom, as well as seriousness” was impeccable]. In all cases, the re-opening of schools is constituting, at the very least, an amplifying factor in the spread of the virus. 

As a result of this second wave of infections, governments are imposing new sets of restrictions. In particular, in the UK the government extended the emergency state for six more months and has taken a U-turn on public exercises (bars and restaurants must close by 10pm) and on business policies (once again suggesting people to work from home whenever possible). It seems to be a repeat of what happened in March-April, when the government declared a total lockdown after a series of initial restrictions. Press reports suggest that a total lockdown could be declared in coincidence with the two-week school holidays at the end of October. 

Needless to say, these new restrictions will take their toll on economic activity in Q4, making the materialisation of the so-called V-shaped recovery even less likely to occur. The big hope of having a vaccine ready by this winter seems to be vanishing rapidly, leaving us all no other option than co-existing with the virus for a few more months, perhaps until the summer of 2021. Financial markets will react to this new situation with further corrections in equity valuations and, given the continued accommodative stance by central banks, with a further fall in sovereign bond yields. 

by Brunello Rosa

21 September 2020

The Abraham Accords Peace Agreement, signedbetween United Arab Emirates, Bahrain and Israel in Washington last week, is aimed at the normalisation of the former two countries’ diplomatic relations with Israel. It marks the shift towards various new geo-strategic equilibria being reached in the Middle East.

This process had begun in 2011, when the Obama administration started to withdraw US troops from Iraq. It continued in 2014, with the end of the US fighting mission in Afghanistan, and was then epitomised in 2015 by the Joint Comprehensive Plan of Action (JCPOA) signed between Iran and the five permanent members of the UN Security Council, plus Germany and the EU. Obama’s aim, following Metternich’s and (more recently) Kissinger’s example, was that of creating a “balance of power” among the major countries in the region, to allow a gradual withdrawal of the US from the Middle East, which had become less strategically important since the beginning of the shale oil and gas revolution. To achieve that goal, Obama aimed at creating a balance of power between NATO (represented by Turkey), Sunni Muslims (Saudi Arabia), Jews (Israel) and Shia Muslims (hence the JCPOA with Iran). 

The plan failed for two main reasons. First, as soon as the US started to withdraw from the region, Russia entered it with full force, becoming a decisive player. Second, the new US administration led by Trump reneged on the JCPOA and marginalised Iran in favour of the traditional US alliances with Israel and Saudi Arabia. This has led to an escalation of tensions with Iran, culminating in the assassination of General Suleimani by the US at the beginning of 2020.

Between 2016 and 2020, the only two countries that managed to make serious advances in the region were Russia and Turkey, the two deciding in effect to partition between themselves spheres of influence in Syria, Libya and the Easter Mediterranean. 

The Abraham Agreement marks the beginning of a new phase. First of all, the notion that in order to achieve a durable peace in the region, the Palestinian question needs to be addressed first, with the creation of two states between the Jordan River and the sea (deriving from the 1993 agreements in Oslo) has been wiped out. The logical order has been seemingly inverted. Rather than Palestinian statehood being a prerequisite to Sunni Arab states recognizing Israel, Sunni countries of the region will instead start normalising their relationship with Israel first, and this normalisation might eventually lead to the creation of a proper Palestinian state in the future. 

Second, the fact that the US administration was actively involved in the mediation process via its secretary of State Mike Pompeo, and the fact that the agreement was signed in Washington, means that the US is still actively engaged in the process. In other words, only when a new geo-strategic regional equilibrium is reached the US may start to dis-engage. The Democratic candidate Joe Biden has committed to continuity of this approach as well. 

Third, Turkey, as a NATO member, will be less able to play its own game in the region, having to abide by the superior interests of the US and of the alliance generally. 

Fourth, for the first time since 2015, Russia has been placed on the backfoot, and could not dictate its conditions. 

Finally, as it seems that many other countries in the region are now aiming at normalising their relationship with Israel as well, it is possible that this new, more pragmatic approach to a seemingly unsolvable problem might have the ability to lead to a new geo-strategic equilibrium being reached in the Middle East. 

by Brunello Rosa

14 September 2020

Last week the UK government presented a bill to regulate the smooth functioning of the internal market following the withdrawal of the UK from the EU on January 31st, 2020, which will exert its full effects starting from January 1st, 2021, at the end of the so-called transition period. As has been widely reported by the media, many clauses of the internal market bill override the provision of the so-called Northern Ireland (NI) protocol, which was signed between the EU and the UK alongside the Withdrawal Agreement (WA) in order to ensure that a physical border between Northern Ireland and the Republic of Ireland does not return following the UK’s departure from the EU. 

As was clear from the very beginning, the implementation of the so-called Irish backstop would have effectively put a customs and regulatory border in the Irish sea, de-facto breaking the “union” of the Kingdom, while leaving Northern Ireland within the EU customs union. For that reason, Theresa May repeatedly refused to accept that option, considering that “no UK prime minister could ever accept” such a condition. Boris Johnson instead revitalised the plan, and that was the key to unblocking the negotiations with the EU in November 2019, perhaps knowing that he would have reneged that pact less than a year later. 

The UK government has explicitly said in parliament that the internal market bill would break international law and that the government’s intention was in fact that of overriding the Withdrawal Agreement with domestic legislation. Top EU officials (starting with the leaders of the Council and the Commission, Charles Michel and Ursula von der Leyen, respectively) have called on the UK to respect the pacts signed with the Withdrawal Agreement and the Northern Ireland protocol (pacta sunt servanda, tweeted von der Leyen). 

Where does all this leave the ongoing UK-EU negotiations?The two sides agreed that any deal would need to be reached by the EU Council by October 15th, to give enough time for EU parliament and national parliaments to ratify the treaties. For this reason, the EU sent the UK the ultimatum of either withdrawing the internal market bill or making it compatible with the Withdrawal Agreement and NI protocols by the end of September 2020, in order to have at least 15 days to make a final attempt to strike a skinny free-trade agreement (FTA).

This FTA would be even less ambitious than the one the EU recently signed with Canada (the so-called Canada-minusFTA). But it is self-evident that, given the tight schedule, the risk of a no-deal scenario has returned with a vengeance.    

Is this just hard-ball negotiation tactics by Boris Johnson? One could suspect that, with deadlines approaching, the two sides are trying to play chicken to see who gives up first. That’s a possibility. However, Boris Johnson is on the record saying that for him a no-deal scenario is a perfectly legitimate and desirable outcome. Also, “no deal” is the only logically consistent end-point of his entire Brexit campaign. 

Finally, no deal is the only way the UK would have a proper and final clean break from the rest of the EU, allowing maximum freedom in terms of state aid, taxation and regulatory divergence. It would be the final and cherished prize to secure in return for all the hardship of Brexit. Therefore, we do not think that this is just negotiation tactics. If the final outcome is no-deal, Johnson would sell it as his personal victory. 

What’s wrong with a “no-deal” outcome?While the UK can gain something in the short term from reneging on the pact with the EU that was signed just a few months back, doing so would represent a terrible precedent. For a country aiming at “striking trade deals around the world” (such as the one it recently signed with Japan) as the “Leave” propaganda said, being perceived as a counterparty that not only does not respect its word, but does not even respect the treaties it signs, would be a terrible signal to send to other countries that could be potentially interested in striking a deal with the UK. 

The UK has taken hundreds of years to move from encouraging piracy to providing one of the most reliable legal systems in the world. If Boris Johnson decides to go down that route, it could cause severe damage to the country’s international reputation. With the UK already being one of the countries hardest-hit by the economic repercussions of Covid, its PM needs to be careful in inflicting more damage from the effects of a no-deal Brexit, even if (as we discussed in our column of May 11th) he could get away with it in the short run by blaming Covid for the economic consequences of a disorderly exit from the EU.  

by Brunello Rosa

7 September 2020

During the latest Jackson Hole symposium of central bankers and academics, which was held for the first time in a virtual format and, therefore, was open to the broader public, Chairman of the US Federal Reserve Jerome Powell provided the main conclusions reached in the Review of the Fed’s Strategy, Tools and Communication. In our recent analysis, we provide all the details of that decision.

In a nutshell, the Fed decided to introduce what has been labelled as Average Inflation Targeting (AIT), which means that the Fed will allow inflation to overshoot the 2% target for brief periods (by a limited amount), in order to make up for the lost price level during periods of target-undershooting. This system is clearly designed for the present period, during which the Fed has been undershooting the inflation target for a very long time. The new framework will therefore allow the Fed to keep rates low for longer, and to look through potential inflation spikes that may arise due to Covid-induced supply-side constraints.

Clearly, a potential side effect of this approach (typical of all “averaging” or “level-based” regimes) is what happens when there is a persistent period of above-target inflation. In theory, the Fed should then keep policy rates higher than they otherwise would, to send inflation below target for some time. In turn, that would possibly induce a marked slowdown or recession (as occurred during Paul Volcker’s experience to combat spiralling inflation in the 1970-80s). Although now that seems a distant problem, it might occur at some point if stagflationary pressures were to emerge. The Fed will likely cross that bridge only when the time comes to do so.

In any case, the immediate policy implication is that the Fed will likely keep interest rates at record lows for longer than previously thought, as now the Fed can wait for inflation to be above target before increasing rates, rather than start raising rate as soon as inflation starts moving, consistently and convincingly, towards the target level.

This has clear market implications for bond and equity prices (likely to be supported by the lower rates), credit spreads (likely to remain more compressed than would otherwise be the case) and for the US dollar, which will likely stay as weak as it currently is, and remain so in the future as well. Long-term yields have briefly edged up on the announcement of the Fed’s approach, as the implied breakeven inflation level embedded into them rose, together with inflation expectations.

The real question is how all other central banks (in the G10, but also in EMs), will react to this move by the Fed. They will not be able to afford staying put: when the “mothership” that is the US Federal Reserve moves, all others will have to react, and move in the very same direction. The real risk is therefore that a new race to the bottom will now ensue, of interest rates and other accommodative monetary policies. Such a process may be additionally likely as the other central banks seek to prevent their own currencies appreciating versus the dollar, in the middle of the most severe economic contraction since the Great Depression. 

The first G10 central bank to meet after the Fed announcement was the Reserve Bank of Australia (RBA). As discussed in our review of the policy meeting, the RBA decided to leave its policy rates unchanged, but did increase the size of its credit easing facilities. This week, the Governing Councils of the ECB and of the Bank of Canada will each meet. As discussed in our previews, we expect both central banks to keep their policy stances broadly unchanged, while keeping a clear easing bias and  adding a dovish twist as a response to the Fed’s policy review.

In the next few months, these and other central banks will meet. The risk is that another significant round of policy easing, carried out by a number of central banks, is just around the corner.

by Brunello Rosa

31 August 2020

Japanese PM Abe Shinzo resigned at the end of last week, suffering as he is from a pathology (ulcerative colitis) that had already previously caused him to resign in September 2007, back when he had only been in office for one year. This institutional crisis could not come at a worse time for Japan, which is facing a second wave of Covid and is in the middle of the worst economic contraction in decades, with GDP having fallen by 7.8% q/q in Q2, the third consecutive quarterly drop in the country’s GDP. 

Abe’s second term in office started in December 2012, with the resounding victory in the general election that led to a solid majority for his party, with 328 MPs out of 480 in the House of Representatives of the Diet. With the support of a strong cabinet featuring former Prime Minister Tarō Asō as Deputy Prime Minister and Finance Minister, Yoshihide Suga as Chief Cabinet Secretary and Akira Amari as Economy Minister, Abe launched his celebrated Abenomics, consisting of three “arrows”: ultra-loose monetary policy, initial fiscal stimulus followed by fiscal consolidation, and structural reform. 

As generally happens, the policy package started with the lower-hanging fruits, i.e. massive monetary easing in 2013, which led to the adoption of QQE (quantitative and qualitative easing), followed by the introduction of various forms of forward guidance, credit easing, negative policy rates and (last but not least) yield curve control. All these monetary innovations led to the weakening of the JPY, and the massive rise in Japanese equity valuations (Nikkei and Topix), with Japanese companies recording record profits, often hoarded abroad.

The other two arrows proved less successful: following an initial JPY 10tn stimulus package, fiscal consolidation came with the rise in the consumption sales tax, from 5% to 8% in April 2014. That fiscal tightening led to the Japanese economy to a stall and, eventually, a recession in Q2 and Q3 of that year, which plagued Abe’s second term in office. The decision to proceed with the planned second hike in the sales tax rate (from 8% to 10%) in 2019 led to similar results, with the ongoing recession aggravated by the arrival of Covid. The pandemic has also forced the government to postpone the flagship event with which Abe wanted to conclude his period in office: the Olympic games in Tokyo. They will now have to wait until 2021 at least.

The pandemic has also forced the government to postpone the flagship event with which Abe wanted to conclude his period in office: the Olympic games in Tokyo. They will now have to wait until 2021 at least.    

The third arrow has been even less successful, as the planned and implemented structural reforms were watered down and ineffective at best, in a country where the population is rapidly ageing and shrinking (from almost 130 million today to around 100 million only a few decades from now, barring a significant change in birth rates or immigration). As a result of all this, the overarching aim of bringing the deflationary period to an end after almost thirty years has miserably failed, with inflation struggling to remain above zero. Other notable failures of Abe’s second term in power were the attempt to hold a referendum to change article 9 of the constitution in order to allow Japan to re-arm, and the failure to settle an old territorial dispute with Russia. 

However, Abe’s period in office also saw some important successes, such as his ability to remain in power for 7 years in a row, ending the endemic instability of Japanese governments that had defined the decades before Abe’s ascent.  The re-vitalisation of the Trans-Pacific Partnership (TPP) after Trump ditched it in 2016 was another success (it has been relabelled the Comprehensive and Progressive Agreement for Trans-Pacific Partnership). One could also classify as a success Abe’s ability to forge a good working and personal relationship with US President Trump, which may have helped lead the US to engage with North Korea, and stop North Korea’s missile tests of rockets sent over the Japanese territory.

What lies ahead for Japan? Next year, the general election was supposed to bring a new LDP leader and PM to power; now the process is accelerated. The race has begun, with credible contenders being Fumio Kishida (LDP’s head of policy), Shigeru Ishiba (former defence minister), Yoshihide Suga and the old Tarō Asō, who would not mind a final stint in power before retiring. More than their personalities, it is Japan’s policies that will matter. Assuming that for the time being monetary and fiscal policies will remain amply accommodative, one needs to understand how Japan will position itself strategically in international affairs, at a time when the US election is as uncertain as ever and China has become more assertive than ever. The next few months will determine the path Japan will follow in coming years.

by Brunello Rosa

24 August 2020

The Democratic National Convention (DNC) was held in Milwaukee last week – mostly in virtual format, given Covid-19 – with the nomination of Joe Biden as the Democratic candidate for the US presidential election on November 3rd. On August 11th, Biden chose Kamala Harris as his running mate and candidate for the Vice-Presidency of the United States. With Harris’ appointment and Biden’s nomination by the Democrats, the race for the White House against the incumbent Republican President Donald Trump and his VP 

Mike Pence has officially begun. 

Donald Trump is currently under attack for his management of the Covid-19 crisis, with the number of infected people in the US having reached 5.6 million people and the number of deaths 175,000, the highest number of confirmed cases and reported deaths in the world. This has led to the sharpest contraction of the economy since the Great Depression of the 1930s (-32.9% SAAR in Q2), with a rise in the number of unemployed people, which reached in  14.7% of the workforcein April 2020, before falling to the current level of 10.2%. The successful management of the pandemic and the economic track record will not be arguments that Trump will be able to credibly run on during the electoral campaign. Equally, the divisive and polarising nature of his presidency, including the rise of “white supremacist” movements across the US, will make Trump’s re-election harder. 

At the same time, the incumbent President always enjoys a special status, which gives him a slight head start in the race. Policies, including further tax cuts and fiscal stimuli, can be adopted between now and the day of the election in an attempt to swing voters in his favour. Some further “successes” in foreign policysuch as the recent agreement between the UAE and Israel, or the continued implementation of the Phase-1 deal with China can be used as “weapons of mass distraction”. So, in spite of his recent difficulties, it would be wrong to write Trump off at this stage.

In the opposite camp, Biden has emerged as the obvious centrist choice to fight against a polarising figure such as Trump. He can enjoy the support of former presidents Obama and Clinton (whereas Trump faces the disapproval of former presidents such as G.W. Bush and other GOP grandees), and Trump’s mistakes on Covid and the economy are defining the campaign for him. The choice of Harris as running mate is supposed to bring on board the votes of ethnic minorities and socially disadvantaged groups, in an attempt to win back crucial votes in swing states that in 2016 allowed Trump to win the race even with nearly 3 million fewer votes than Hillary Clinton.   

At the same time, some of the Republican votes that might have gone for Biden just to get rid of Trump could be put off by Biden’s choice of a VP – a VP who could potentially become President, if Biden became “unavailable” for whatever reason during his first term in office. Additionally, Harris’ centrist approach might not be enough to win back the votes of the party’s left wing, represented by Bernie Sanders and Alexandria Ocasio-Cortez. 

Pollsters are divided as to what the eventual outcome of the election will be. Recent national polls suggest that Biden is ahead, but we know that what really matters is the distribution of votes in key swing states. Those using sophisticated statistical methods that managed to predict Trump’s surprising victory in 2016 are also divided. The outcome is still uncertain at this stage, therefore. There are however three things we can be sure about: 1) The campaign will be acrimonious, and full of ruthless accusations thrown by both sides at their adversary. 2) In the event of a narrow defeat in the electoral college, Trump will fight hard not to leave the While House. 3) The US will emerge more divided than ever after this campaign, and a lot of effort will need to be made by whoever wins to unite the country behind the President.  

by Brunello Rosa

17 August 2020

During the 20th century Europe was been plagued by dictatorships. The most known where those in Germany, Italy, Spain, and Portugal. Adolf Hitler and Benito Mussolini were removed from power at the end of World War II, when Germany and Italy returned to democracy; Portugal’s António Salazar lasted until 1968 (and his authoritarian government remained until 1974) and Francisco Franco until 1975, the year of his death. But somewhat incredibly, dictatorship remained a viable option in many other parts of Europe for much longer than this. 

In Greece, the dictatorships of the colonels (τὸ καθεστώς τῶν Συνταγματαρχών), also known as the Junta (η Χούντα), lasted from 1967 until 1974. In Jugoslavia, the regime by Colonel Josip Tito lasted for a decade beyond the year of his death (1980), until the division of the country and Balkan wars of the 1990s. In Eastern Europe various forms of authoritarian regimes stayed in place until 1991, when the Soviet Union collapsed. Since then, the progressive expansion of the European Union and of NATO has gone together with an expansion of democratic regimes in the region. 

In some cases, such as in the Baltic countries (Estonia, Latvia, and Lithuania), the adoption of the Euro has also meant a consistent transition to democracy and political freedom. 

Other countries, such as Poland and Hungary, have backtracked on their progress towards democracy, with the arrival of the Kaczyński brothers and Viktor Orban, respectively. For this reason, both countries are now under the procedure foreseen by Article 7 of the EU Treaty for violating basic principles of the EU, including academic freedom, freedom of expression (particularly freedom of the media), and the independence of the judiciary. In other cases, such as in the Czech Republic, right-wing populist leaders threaten the existing democratic regime. 

The two most remarkable cases in Europe remain Ukraine and Belarus. Ukraine has gone through a very complicated transition, including having to deal with the annexation of Crimea by Russia in 2014. The election of Volodymyr Zelensky in 2019 seems to have normalised the situation – or at least frozen the status quo, for the time being. Clearly, Ukraine remains in a situation that is less than ideal, as half of the country (especially its easternmost regions) remains under the heavy influence of Russia, and no real progress seems to be taking place in the negotiations for the association of Ukraine with the EU. 

The second case, Belarus, has come back to the fore in the last few days, with the recent re-election of incumbent president Aljaksandr Lukashenko, who has been in power without interruption since 1994. The election was officially won by Lukashenko with 80.1% of votes, versus 10.1% for his only remaining rival, Svjatlana Tikhanovskaya. But the EU and the US have not recognised the result the elections, and are now discussing possible sanctions on Belarus. As violent riots occurred in the capital Minsk as well as in other parts of the country, Tikhanovskaya had to flee the country in order to avoid being arrested, and will now have to continue her fight from Lithuania. The question is whether Lukashenko will manage to stay in power for a long time yet, and eventually pass the baton to his young son (as he has planned for a long time) or if he will be ousted from power. The answer to this question probably lies in Moscow.

For decades the fragile Belarus economy counted on subsidies coming from Russia, assuring it full employment, rising wages, and the well-being of its population. But as Russia itself ran into economic difficulties following the collapse in oil prices in 2014, its economic help started to wane, and with it, political support for Lukashenko’s regime. The president cannot last unless Putin and Russia support him. So, Putin will have to decide what to do; that is the reason for the recent phone conversation held between the two presidents. Lukashenko warned Putin that the riots pose a threat to the stability of Russia as well. In a a not-so-veiled request for help, he claimed that if the riots do not get stopped in Belarus, they will spread to Russia as well. That’s why a military intervention by Russia in Belarus cannot be ruled out at this stage. 

For some time, the idea has existed that the president of Russia would also become president of Belarus, in something akin to a new confederation being formed between the two states. This seemed to be one of the options that Putin was considering to extend further his own mandate within Russia. However, now that Putin has managed to change the Russian constitution, allowing him to remain in power until 2036, this option seems to be less palatable, considering the lack of support among the people in Belarus for a sort-of “annexation” of their country by Russia. At the same time, a nationalistic approach, in which Belarus would try to re-assert its independence from Moscow, is not particularly popular among the wider populace either. 

So, perhaps the only option remaining on the table for Putin is to keep Lukashenko in power for longer and increase economic and financial support for the country. But this solution may prove to be more temporary than either of the two presidents desire, exposing them to further revolts.  

by Brunello Rosa

10 August 2020

After the disastrous collapse in economic activity recorded in Q2, with real GDP falling by double digit percentage points in many economies, including in the most advanced ones, the global economy is attempting a timid rebound in Q3. The re-opening of economies after months of widespread lockdown, when 1/3 to half of the world population was estimated to be subject to more or less draconian restrictions, is facilitating a comeback in economic activity. However, this rebound is uneven and uncertain at best. In its latest statement, the US Federal Reserve’s FOMC warned about a slowdown in this timid rebound, as signalled by many leading and contingent indicators. 

Governments remain alert and active in their plans to stimulate economic activity. Among others The US is preparing its third fiscal stimulus package, the EU has just adopted the new Recovery and Resilience Facility, and the UK has prorogued its furlough schemes (together with other forms of fiscal support). 

Central banks remain fully accommodative after having launched what we called “Covid-related forward guidance”. In fact, in August the Reserve Bank of Australia (RBA), in deciding to re-start QE after the lockdown in the state of Victoria, joined the Fedand the ECB in explicitly linking the duration of its monetary stimulus to developments of the virus. 

After the so-called “time-limited” and “state-contingent” forms of forward guidance, in which the central bank will continue to provide monetary stimulus until a certain date arrives or a pre-set economic condition materialises, some central banks seem to have decided to launch a new form of state-contingent forward guidance, in which the condition to be met to reduce the stimulus is fully exogenous. Specifically, central banks will continue to keep policy rates low (or lower) or make asset purchases until there is convincing evidence that the virus has been durably and credibly contained.

 Considering that the number of cases is still accelerating in very large parts of the world, such as in the US, Brazil and India, this means that central banks will keep the tap of liquidity open for the foreseeable future. Most central banks, when showing their implicitly expected path of policy rates, do not show any sign of tightening over the forecast horizon. 

Who is benefiting from this situation in financial markets? 

Clearly risk asset prices have been the ones that have benefited from the combination of monetary and fiscal stimulus (sometimes coordinated in “helicopter money” fashion). But there is plenty of evidence that both equity and credit markets valuations are stretched, as they are under-pricing the risk of the chain of defaults and bankruptcies which is likely to manifest itself in coming months. Perhaps also because of this reason, the clear winner so far seems to have been gold. 

The yellow precious metal has in fact reached and recently overcome the 2000$ per troy ounce for the first time since the Global Financial Crisis. Gold was trading at just over $250 in the early 2000, before starting a glorious rally that brought it to $1750 (monthly prices) during the Euro crisis in 2011-12. After retracing and falling to just over $1000 in 2015, the rally re-started with some conviction in mid-2019 (when the Fed started to implement its “insurance cuts”) with a serious acceleration in the last few months. 

As discussed in our recent in-depth analysis, there are multiple reasons for this rally. Gold is perceived to be a good hedge against inflation, but also deflation (as it is a physical asset, but nobody’s liability, unlike government bonds). It is a store of intrinsic value and is also perceived to be a store of US dollar value, during a time when political uncertainty and turmoil in the US, ahead of the Presidential election in November, is making many investors nervous about the greenback. 

by Brunello Rosa

3 August 2020

Last week, the US Bureau of Economic Analysis released its first estimate of the performance of the US economy in Q2 2020. After the 5% q/q drop in Q1 (a seasonally-adjusted annualised rate, SAAR), in Q2 the economy contracted by 32.9% q/q SAAR. This was slightly less than anticipated (34.1%), but still the largest contraction on record. This quarterly contraction of 8-9% (32.9% divided by four) is in line with the fall in income recorded by other major economies. It is explained, of course, by the adoption of lockdown measures that were introduced in order to slow down the spread of Covid-19. 

As the Federal Reserve Chairman Jerome Powell said during the press conference following the FOMC decision to leave the central bank’s policy stance unchanged in July, this is the largest shock the US has had to endure in recent history. After an unexpected rebound in May and June, the recovery of economic activity since July has slowed down, as has been revealed by non-standard, high-frequency indicators, such as hotel occupancy and credit card use. In its latest statement, the Federal Reserve decided to establish a clear link between the expected path of economic activity and the likely evolution of the pandemic. 

Following the release of the quarterly GDP figures, US President Donald Trump released a tweet in which he wondered whether the US election could be delayed “until people can vote properly, securely and safely.” Even if it is not in the president’s power to decide on the date of the election, this tweet created an outcry in the media and the Democratic party, where it was often viewed as a confirmation of Trump’s authoritarian tendencies and an attempt to undercut the US democracy. Since the power to postpone the date of the election has resided with Congress since 1845, Trump’s tweet must be read as a signal of how he is ready to contest any result that would not see him as the victor in the US presidential race in November, as we discussed in our column on April 20.

But the economy is not the only preoccupation of President Trump at the moment. After putting the popular video-sharing social medium Tik Tok under scrutiny for representing a possible threat to national security, Donald Trump said he was ready to ban its operations in the US, where it counts around 50 million users. The company responded that the data it collects is stored in US-based servers (confirming once again how relevant the concept of digital sovereignty is becoming), with limited and controlled access from its employees. Some read Trump’s move as a way of either jeopardising the potential sale of the US arm of Tik Tok to Microsoft, or as an attempt to reduce Tik Tok’s price. 

This is yet another confirmation that one of the main battlefields of the ongoing Cold War 2 between US and China is the tech race between the two superpowers. In a separate, but related field, our recent report on the “stunning” alliance between China and Iran discusses how Cold War 2 is taking shape in the more traditional domain of strategic alliances. 

While all of this is going on, the Democratic contender in the November race, Joe Biden, will soon announce the choice of his running mate. Many see this as a potential turning point in the campaign. Biden is set to choose a candidate who, unlike himself, is not old, or male, or white, and for this reason the most credited contenders for the position are Susan Rice and Kamala Harris. But this choice must be considered in the broader context of the US presidency. 

Biden, if elected would at 77 years old be the oldest US president in history at the time of his inauguration. He already hinted at the possibility of running for only one term, making his VP the natural candidate for succession in 2024. There is also a possibility that Biden could resig duringhis first term, which would of course would directly make his VP ascend to the presidency. Knowing all this, any Republican voters or swing voters who might be inclined to vote for Biden just to make sure that Trump is not re-elected in November, might want to be reassured that Biden’s running mate is as mainstream a politician as possible.

by Brunello Rosa

27 July 2020

We have often discussed how a key component of the ongoing Cold War II is a technological conflict between the incumbent dominant power (the US) and the rising star (China). Last week, US microchip producer Intel, for decades the undisputed leader in its sector, announced that it had fallen behind its development plans by at least one year, thus leaving its main competitor, TSMC a Taiwan-based company, as the leader in its field. This has been read by some analysts as the latest confirmation of the US losing its dominant position in technology, an area that for decades was the ultimate key to American success.

But this is only the last episode of a much wider saga. In particular, the battle for the distribution of 5G technology represents a significant front in the ongoing tech wars. Recently, the UK has also joined its fellow countries of the Five Eyes (US, Canada, Australia and New Zealand) in the broader Anglosphere, with the decision to gradually phase out Huawei in the provision of technology for the 5G British network. This was a decision that came after repeated and heavy pressures were placed on PM Boris Johnson by the US. 

In this raging tech war, we must note the impetus that the Coronavirus pandemic has given to cyber-wars, as we discussed in our recent two-part report on the subject. Part 1 of that report focused on US and international developments, Part 2 focused on national developments in Russia, EU, Israel and China. The rapid increase in digital technologies that has occurred in order to provide business continuity during the long months of widespread lockdowns has made most countries, institutions and companies much more vulnerable to cyber attacks than was already the case before the pandemic began.

In the future, we will have to assume that the failure of diplomatic avenues in any serious dispute between countries could result in one of those countries carrying out a cyber attack. Such attacks will, perhaps, be launched by non-state entities at the behest of a state, in order to provide that state with “plausible deniability”. 

These technological developments will certainly impact traditional areas of finance as well, such as banking. As we have discussed in our recent in-depth report on the future of the banking industry, traditional lending institutions already find themselves under siege by fin-tech developments coming from the private sector. On the other side of the spectrum, central bank digital currencies (CBDCs) developed by the public sector will pose an additional threat to the traditional business model of financial institutions. 

Both sides will continue to squeeze banks in the middle. 

Given the widespread use of digital technologies, fin-tech developments will continue unabated in their aim of increasing efficiency and granting access of financial services to larger segments of the population which otherwise have little exposure to financial services. Central banks (with China and Sweden leading the race) will continue their journey to the eventual adoption of CBDCs, which are seen as the key to solving the next systemic crisis. 

Traditional banks will have to adapt their modus operandi to fit this radically changed environment. As we discuss in our report, the key elements of their new business model will have to be digitalisation, a consumer-centricity, and further specialisation regarding local needs. This will be a process that will surely lead to further consolidation in the industry, with fewer players left on the battleground afterwards.

by Brunello Rosa

20 July 2020

Since last Friday, the special EU summit to decide on the implementation of the Recovery and Resilience Facility is taking place in Brussels, with European leaders meeting in person for the first time after months of video conferences. 

The summit started with a great distance between the positions of the so-called Frugal Four (Austria, Netherlands, Denmark and Sweden) – which became Frugal Five when Finland joined the group – and those of the Mediterranean front of Italy and Spain (which is supported by France). The former group wants a reduction of the overall package proposed by the EU Commission, namely EUR 500bn in transfers and EUR 250bn in loans, and a significant reduction in the amount made up by transfers. Within this group, the most aggressive position is expressed by the Netherlands, whose PM Mark Rutte seeks to win a majority in his country’s parliamentary election next spring. The Netherlands, for a change, is not simply the “bad cop” of the duo with Germany. Rather, the two countries entered this meeting with two different strategic objectives. The second group of countries wants the overall size of the program to be left unchanged, and wants transfers to remain the bulk of it.

There is also a third front at the table, representing the nations of the so-called Viségrad group (Czechia, Slovakia, Hungary and Poland). Those countries, among the largest beneficiaries of EU funds (Poland in particular) want to make sure that their quota of funds in the new Multiannual Financial Framework (MFF) remains intact.  

Alliances across regions (North/South, East/West) and political families (People’s party, Socialists and Democrats, Liberals) are variable, and subject to change opportunistically. 

In the middle of these different positions is Germany, with Angela Merkel trying to broker a historic deal during the period in which Germany holds the rotating EU presidency, to make sure that the eventual result is acceptable to everybody. Germany is doubly putting its face on this deal. 

The EU Commission that made the initial proposal discussed at the summit is led by Ursula Von der Leyen, the former German defence minister and protégé of Angela Merkel. In addition, Merkel herself is looking to complete her long period in service with an agreement that could prove historical. Merkel’s goal is passing the EU to the next generation of European leaders, with some of the elements of solidarity that characterised the initial project still intact. So, Germany cannot risk that this summit ends with no results. 

Given such distance between the positions of various blocs of countries to begin with, the sessions on Friday, Saturday and Sunday not surprisingly finished in acrimonious discord. 

Various proposals have been presented by EU Council President Charles Michel to reduce the overall size of the package and the share of that package made up by transfers rather than loans, to make the deal more acceptable to the Frugal Five. The latest proposal foresees EUR 390bn of grants and will be discussed starting from Monday afternoon. We expect that, eventually, a compromise will emerge, if not at this meeting, at a new one later in July.

 by Brunello Rosa

13 July 2020

The number of Covid-19 cases worldwide is increasing. It has now nearly reached the 13 million mark, causing almost 600,000 reported deaths. Some countries, especially in Europe and Asia, are experiencing an increase in new cases, though only to a limited extent so far, after re-opening their societies following long periods of lockdown. In other countries, such as the US and Brazil, the situation is worse; according to some experts, infection rates may already be out of control in these countries. In the US in particular, where the number of cases has now reached 3.2 million, the spread of the virus is still increasing exponentially, suggesting that the adoption of new social-distancing measures is likely to occur during the next few weeks.

As lockdown measures have eased, economic activity has been picking up, recovering from the lows touched in Q1 and Q2. Unless restrictions are re-imposed to the same extent as occurred during the first part of the year, or new restrictions imposed upon large economies such as the US have massive spillovers to the rest of the global economy, Q3 GDP growth should show a positive figure in many countries, given base effects. 

In spite of the recovery in economic activity, the support of economic policy remains essential. As far as fiscal policy is concerned, most governments are still providing stimulus by way of new or renewed packages. In the US, a third fiscal easing package is underway. In the UK, the Chancellor of the Exchequer has just announced a new set of measures to support economic activity, such as the temporary reduction of VAT on certain products and services and of the stamp duty on certain real-estate transactions.  

In the EU, this week there will be another summit to make progress towards the approval of the EU Recovery and Resilience fund, which should support the economies most hit by the Covid pandemic, such as Italy and Spain.  

In all this, central banks are taking a breather. In recent weeks, after the massive monetary easing programs announced during H1, most central banks are adopting a wait-and-see approach. Some of them, such as the Reserve Bank of Australia, have even started to reduce their intervention in markets as the economy stabilises. This week, there will be the monetary policy meetings of the European Central Bank (ECB), Bank of Japan (BOJ) and Bank of Canada (BOC). The BoC will release its first set of forecasts since the pandemic begun, and the BoJ will update its economic outlook. As we have written in our preview, we expect them not to change their policy stance, while remaining ready to add monetary stimulus should economic and financial conditions deteriorate in coming weeks. 

Central banks, which have been at the forefront of the policy response during the global financial crisis, have already used most of their conventional and unconventional arsenal. At this point, they prefer fiscal policy, and regulation, to be in the driving seat. At the end of July, the FOMC of the Federal Reserve, which sets the tone for most central banks with its decisions, will meet. It is likely to adopt a similarly cautious approach, although with the worsening healthcare conditions in the US discussed above, the meeting might result in the decision to further increase its stimulus, for example by widening the depth and spectrum of its credit-easing facilities. 

by Brunello Rosa

6 July 2020

A few weeks ago we warned that the world will look very different after Covid from how things were at the end of 2019. Some of the changes we envisioned are already occurring. 

We mentioned how China would try to use the crisis to make geo-strategic gains relative to its rivals, primarily the US and, more broadly, the Anglosphere. In this respect, the new more assertive geopolitical stance taken by China was visible in the military exchange that occurred between China and India in the disputed territories of the Himalayas.  This direct military confrontation risks pushing India more towards the US sphere of influence, at a time when US President Trump has already expressed sympathy towards authoritarian or nationalistic leaders like Narendra Modi. 

But the geopolitical confrontation between China and the Anglosphere is occurring on other fronts as well. As we discussed in a recent column, the blame game over the origin of the Covid-19 pandemic must be interpreted as part of a wider containment strategy with regard to China, a strategy which also includes the probable decision by the UK government to gradually phase out Huawei from its 5G network, following similar steps already taken by both the US and Australia. 

Meanwhile, the US is still mired in the middle of a surge in Covid-19 cases, with  erratic management of the crisis by US President Trump. The US now has about one quarter of the 11 millioncases of Covid recorded worldwide. As a result, the EU, which has just re-opened its external borders, has excluded the US from the list of countries from which citizens can arrive without having to undergo a period of quarantine. The US is about to enter one of the most heated presidential elections in its history, with Trump already openly speaking of “rigged” elections, alleging irregular vote-by-mail schemes and ballots printed by foreign countries. 

There is even the risk that, unless the Democratic candidate Joe Biden obtains a large majority in the electoral college, the president will refuse to accept the result of the election and will not leave the White House in January 2021.  

In the middle of the US and China, there is always Europe, which is trying to overcome its many contradictions. As we discussed in our recent in-depth analysis, the EU is in the middle of a difficult negotiation regarding the Recovery and Resilience Fund, with the Frugal Four (Sweden, Denmark, Austria and Netherlands) asking for much stricter conditionality attached to any funds sent to the countries that have been most impacted by the crisis, primarily Italy and Spain. In a recent interview, Greek PM Kyriakos Mitsotakis said that he will not accept the approval of a recovery instrument with too much additional conditionality compared to regular fiscal coordination and surveillance. 

In our analysis we also discussed the national implications of such a deal, in particular in France. There, President Emmanuel Macron decided to sack Prime Minister Edouard Philippe, following the defeat of the president’s party in the local elections last week. He substituted Philippe, who had become more popular than the president for his good management of the Covid emergency, with Jean Castex, another “Enarque” who advised the president on the re-opening of the economy post-lockdown. 

These movements, apparently simple domestic politics, are of the greatest importance ahead of the 2022 Presidential election. As we have said many times before, if Macron does not win a second mandate, the entire European integration project could be in serious jeopardy. 

by Brunello Rosa

29 June 2020

Last week, equity indices suffered despite a rebound in economic activity in some key economies. This occurred as a rise in COVID-19 cases, especially in the US and Brazil, as well as fresh warnings over the global growth outlook and the Fed’s warning of a cap to ‘shareholder payouts’ all weighed on market sentiment. 

On a weekly basis, global equity indices fell (MSCI ACWI, -0.6%, to 524), driven by the US (S&P 500, -0.5% to 3,084) and the EZ (Eurostoxx 50, -1.5% to 3,219). From the beginning of the year, the S&P 500 index is down 7%, Eurostoxx 50 is down nearly 15%, the UK’s FTSE 100 is down 18% and Nikkey 225 5%. These figures are very much in line with what we  predicted a few months ago, perhaps with the only exception of NASDAQ, which has surprised us as well as market participants with a more positive than expected performance. The NASDAQ is up 9% year-to-date, mostly due to the fact that pandemic has further boosted the use of technology for business continuity.

Have these depressed valuations re-aligned equity indices with economic fundamentals? We don’t think so. Last week, the IMF released a revision of its World Economic Outlook (WEO), which featured a significant further downward revision of expected global growth, from the -3% predicted in April to -4.9% predicted now. US growth is  expected to be -8.0% in 2020 (a 2.1% downward revision as compared to April’s prediction), the UK -10.2% (a -3.7% downward revision as compared to April’s), and the Eurozone at -10.2% (a -2.7% downward revision). These new forecasts are now more aligned with our own more pessimistic estimates made in April. This week, we will publish our revised forecasts alongside the Strategic Asset Allocation.  

Recently, the OECD went even further than this economic outlook of the IMF. In its June forecasts, the OECD foresees a 6% contraction in global GDP (if no “second wave” of the pandemic occurs – the so called “single-hit scenario”), and -7.6% contraction in case of a second wave (the “double-hit scenario”).  It expects the US to lose roughly 7.3%/8.5% of GDP in 2020 (depending on whether or not a second wave occurs), the Eurozone 9.1/11.5%, and the UK a staggering 11.5/14%. So, either these growth forecasts are too grim, or else market valuations are too optimistic.

At the beginning of the year, we warned that there was a large discrepancy between risk asset valuations, especially equities, and economic fundamentals. The collapse in valuations following the global outbreak of Covid-19, which marked the beginning of the fastest bear market in recent history, had temporarily solved that discrepancy, by bringing valuations closer in line with economic fundamentals. But the rapid recovery in equity indices (pushed by central bank liquidity) led also to the manifestation of the shortest bear market in recent history, with valuations departing again from economic fundamentals. 

In our recent analysis, we warned about the possibility that a U-shaped (or W-shaped) recovery could be accompanied by a V-shaped rally in financial markets. However, our recent in-depth analysis shows that equity valuations seem to be mis-aligned not just with macroeconomic fundamentals, but also with microeconomic variables that serve as an input for equity valuation models, such as expected earnings per share. There is also a mis-alignment with the signals from the credit market, in particular the expected default rates. What is underpinning high valuations seems to be only low interest rates (both current interest rates and expected future interest rates), which is a purely circular argument. Clearly, central bank liquidity has been underpinning valuations for a long time now. It is perhaps to break the virtuous (but also vicious) circle that, after the easing spree of March/April, most global central banks are now adopting a more cautious stance, with a partial withdrawal of some of the extraordinary measures introduced in the last few weeks. 

In any case, the evolution of the pandemic and the global economy remain highly uncertain, and so “prudence” should be the buzzword for market participants at this time.  

by Brunello Rosa

22 June 2020

Last week, China announced that a number of boroughs in Beijing had to be locked down as a result of a new localised outbreak of Covid-19 in the city, possibly originating from another food market. The Chinese authorities said that investigations concluded that the coronavirus strain detected at the Xinfadi market in Beijing came from Europe, even if they admitted that this particular strain “has existed longer than the current coronavirus strain circulating in Europe.”

So, it appears that China is now making accusations of other countries and regions for the possible second wave of pandemic it might be suffering. This is, of course, similar to the way most countries have accused China for having caused the pandemic in the first place, whether “naturally” (if the virus spread out the wet market in Wuhan), or “artificially” (either intentionally, or by accident, given the presence of the notorious research lab in Wuhan itself). What then should we make of this blame game between China and the rest of the world?

One should not be confused by the exchanges of allegations between politicians and even heads of state and governments. In most cases, these allegations are made to assuage the domestic opinion more than to attack the foreign entity, in order to distract attention and divert responsibility away from themselves. This is a usual game in politics. However, there is also something deeper going on now, which makes the current situation different from those which typically exist. 

As we discussed a few weeks ago, we believe that after this pandemic, and after the containment measures that have been adopted to counter this pandemic, the world will look very different from how it was until the end of 2019. In particular, the economic or political power ranking of countries and regions could change on a global scale. 

For certain, the economic and political “distance” between the major global players will be very different: for example, China will be able to reduce the gap with the US on a number of dimensions. The US, with its erratic response to the pandemic, and its inability thus far to rein in the pandemic, will most likely lose ground versus China, whose response to the virus having been much more rapid and forceful. Europe is still debating which policies to adopt to recover from it. 

The US and its closest allies in the Anglosphere (the so-called “Five Eyes”: the USA, UK, Canada, Australia and New Zealand) are trying to respond this evolution of events. Clearly, the first point of attack is about the origin of the crisis, which is undoubtably in China; emphasizing this fact also serves to diminish the relevance of Beijing’s strong response. For the first time in history, countries or state entities (such as Missouri and Mississippi) have expressed their intention to ask for “compensation” or “reparations” in non-war related circumstances, and this will continue to put pressure on China. 

But there are other open fronts as well. As we know, the new Cold War between US and China has several components, one of which is the very relevant technological competition. Recently, the US imposed further restrictions on Chinese tech giant Huawei (which were subsequently partly eased). 

Countries in America’s inner circle, such as Australia, have taken similar measures. This has meant a sharp deterioration in the bilateral relationships between Beijing and Canberra, even despite the fact that China has been the main importer of Australia’s iron ore and coal in the last few years. But in the “new world order” of disrupted global supply chains, geopolitical considerations will trump economic cost/benefit analysis. This is an unfortunate evolution. It will eventually hurt the end consumer globally, as it will lead to a reduced choice of products and higher prices. 

by Brunello Rosa

15 June 2020

In this world of de-materialised data, where the control of the cyber space and the most advanced communication and information technologies seems necessary to gain a strategic advantage versus the geo-political rivals, it is quite dystonic to learn how global and regional powers still consider the control of the sea as a key factor for assert dominance over a geographical area.

We have discussed many times how the new Cold War between US and China was increasingly driven by the technological competition between the two world’s super-powers, in particular in the fields of artificial intelligence, big data and 5G technologies, with the US trying to at least slow down China’s Agenda 2025, foreseeing the Asian giant becoming the world’s first country in the most technologically advanced sectors of the future. More recently, we have discussed how Russia, the world leader in cyberwarfare techniques, was using the Covid-induced crisis to make geo-strategic advances by using its competitive advantage in the field. 

But exactly when all the advanced world is making the greatest use of online technologies to carry on its economic activities and circumvent the restrictions imposed by the lockdowns, we learn how the good old control of key maritime routes and straits, or the acquisition of naval basis is still considered a key ingredient for asserting geo-strategic dominance. 

In the G2 heightening rivalry between US and China, the disputes over the east and south China sea have acquired absolute prominence in determining how the rivalry will evolve, including regarding the still unresolved trade dispute. As discussed in our recent report, roughly $5 trillion of trade passes through the South China Sea (SCS) each year, including oil and natural gas. It’s clear that controlling SCS enables China to potentially choke off these routes and severely impair neighboring economies and global trade.

Press reports suggest that Beijing has steadily fortified seven islands or reefs, equipping them with military bases, airfields and weapons systems. This means, that while US President Donald Trump might be trying to apply the Art of The Deal in the negotiations, China might be applying the Art of War by general Sun Tzu, implying that any comprehensive trade deal with China might need to include a resolution of SCS sovereignty issues, potentially an unachievable result. 

Clearly, China’s difficulty in projecting its geopolitical influence by controlling the seas is a massive constraint, compared to the US historical prevalence over the Atlantic and Pacific oceans. The Belt and Road Initiative (where the “Road” is a maritime route) is a way for China to break that constraint disguised behind commercial interests. 

In other reports, we have discussed how the control of the strait of Hormuz was considered by Iran as a key to re-assert its authority in the Persian/Arabian gulf, potentially impairing global trade of oil from the region. 

Finally, in our recent report, we have discussed how geopolitical tension was rising in the Mediterranean sea, with two open fronts in Syria and Libya, where regional powers are playing their chess game. Turkey and Russia seem now close to reach an agreement on the two fronts, with Tukey having completed its “Open Sea Training” operations (thus extending its maritime influence from the Dardanelles to Cyrenaica), and Russia getting closer to achieve its most cherished goal: naval bases in the west Mediterranean sea (in Bengasi – together with the air base in Al Jufra), to complement its historical posts in Latakia and Tartus in Syria. Controlling what the Romans called Mare Nostrum(“Our Sea”) seems to be, two thousand years later, still a desirable strategic objective.

by Brunello Rosa

8 June 2020

In our column in October of 2018, following Jair Bolsonaro’s victory in the first round of Brazil’s presidential election, we asked: “Will The World’s Next Strongman Come From Brazil?”. Bolsonaro, who had been an underdog in the election until he was stabbed at a campaign event only one month before the vote took place, had already been displaying  all of the characteristics of the strongmen who were already populating the globe at that time (Trump, Putin, Xi Jinping, Orbán, Kaczynski, Erdoğan, Duterte, Modi, etc.), including a passion for (or in his case, a past within) the military, an admiration for non-democratic regimes, and a preference for the use of force to solve international and domestic disputes. 

Fast forward almost two years later to today, and, taking into account the natural tendency of Covid-induced economic restrictions to strengthen autocratic behaviours, here we are: Bolsonaro is not only proving to be the world leader who is most reluctant to adopt containment measures against the spreading of Covid-19, a reluctance which has made Brazil the new epicentre of the pandemic, together with the US, but a judge from the country’s Supreme Court has also accused Bolsonaro of wanting to abolish democracy in Brazil in order to establish an “abject dictatorship”. Justice Celso de Mello, in a WhatsApp message leaked to the media, reportedly said: “We must resist the destruction of the democratic order to avoid what happened in the Weimar Republic when Hitler, after he was elected by popular vote, did not hesitate to annul the constitution and impose a totalitarian system in 1933.” 

These allegations came after Bolsonaro attended a rally at which demonstrators, wearing paramilitary uniforms, called for Brazil’s parliament and supreme court to be shut down and be replaced with military rule, and after Bolsonaro’s Minister of Culture was forced to resign after quoting Joseph Goebbels, the Nazi minister of propaganda. This should not be surprising, given that Bolsonaro packed his government with more than 100 current and retired military officers, including his vice-president and at least 6 cabinet ministers. 

In a recent in-depth analysis by John Hulsman, we discussed Bolsonaro’s record in government, showing how the president of Brazil has been out of his depth over myriad issues hamstringing his erratic presidency. In particular, we noted how three C’shave been plaguing the populist leader:  (lack of) Competence, (lack of) Competition within the right-wing camp, and Corruption; and how these have dramatically morphed together into an existential threat to  Bolsonaro’s continued rule.

At the same time, we also noted the three B’s that could lead to his political salvation: Beef (Agribusiness), Bullets (the Military), and the Bible (the growing number of Brazilian Evangelical Christians). In fact, much of the President’s enduring and loyal political base is clustered around these three groups. These constituencies could help Bolsonaro politically survive, or even thrive, for a continued period of time. Indeed, we concluded our analysis of Bolsonaro’s political record by noting that although Bolsonaro is embattled, he is probably in no immediate danger of impeachment. 

But while the three B’s are protecting Bolsonaro from impeachment, and while his power base is holding for the present, none of the three C’s have been even remotely dealt with. As time passes, and these structural problems turn increasingly septic, what seems now to be a slow unspooling of the Brazilian president may suddenly become a torrent that washes away “The Trump of the Tropics” for good. 

Before this happens, though, the risk remains that Bolsonaro will officially or unofficially suspend democracy in Brazil, bringing a return of the dictatorship that the country abandoned in 1985. 

Picture Credit: Julio Cortez/AP

by Brunello Rosa

1 June 2020

In the last few days, the streets of Minneapolis and other major US cities have been filled by people protesting the treatment of George Floyd, who died while in policy custody. The facts are sadly well known, and the fact that the police officer Derek Chauvin has been arrested did not placate the ire of the African-American community or the wider population. Protests have become violent in the last couple of days, as they have in previous similar occasions, most notably in Los Angeles in 1992, after a trial jury acquitted LAPD officers’ accused usage of excessive force in the arrest and beating of Rodney King. 

So, this type of episode is unfortunately not new, and it will likely happen again in future. What makes this episode peculiar and particularly noticeable in this period is that it is happening as social tensions are clearly on the rise, with a number of protests being staged in various parts of the US against the lockdown measures introduced in many states. The most worrying of these took place outside the Michigan Capitol building in Lansing on April 30, when a number of protesters showed up equipped with firearms. 

This is quite concerning, considering this is a year in which one of the most tense presidential elections in US history will take place. The election will be tense not just because of the logistical difficulties resulting from Coronavirus, or from the fact that the margin between the two contenders is likely to be small, but also because there is widespread concern that if Trump were to lose, he might not accept the result – even were it to come in the form of a verdict from the Supreme Court – and will instead refuse to leave the White House.

Our two-part report on the successes and failures of Trump digs further in this matter. Part Two of the report will be published on Tuesday on R&R’s geopolitical corner.  

These episodes are taking place in the US, but other parts of the world are not immune from this same sort of situation. Protests against lockdown measures are happening in many different countries: the UK, Germany, Australia, Belgium, Italy, Poland, etc. At this stage, most of these protests are motivated by social anger against the restrictions that have been placed on personal liberties. In some cases, they have also been motivated by dissatisfaction regarding the economic impact of the measures being adopted to stop the spread of the virus. But even if the lockdown measures were to be alleviated in coming months, social tension might not ebb. 

In fact, the real economic impact of the anti-Covid measures will be felt in the autumn. In Q2, there was an immediate impact deriving from the closure of economic activities. But those companies that could remain open used these months to process the orders arrived until the end of Q1 2020. But in Q3/Q4 2020 it will be clearer how many businesses have in fact survived, and how many new orders will have arrived. 

The risk is that the collapse in economic activity of Q1/Q2 will have a long-lasting impact on economic systems, with serious repercussions on employment and, therefore, on social cohesion. This is the reason why governments around the world are trying to gradually re-open their economic systems, and why support in the form of government policy will need to remain abundant for the foreseeable future. 

by Brunello Rosa

26 May 2020

We have been following the vicissitudes of the EU integration process for years now. To recap the milestones of our view, we have been saying that unless the EU changes tack, it will be very hard for the incomplete federalisation process of Europe to survive in a new world in which continental economies (the US, China, and India) will make the most relevant geo-strategic and economic decisions. Covid will make this new world come sooner than anticipated, even if the relative ranking of countries will be different than would have otherwise been the case. 

The EU is currently an incomplete transfer union, in which resources (human, physical and financial capital) move from the periphery to the centre. The two main poles of attraction have been the UK (within the EU) and Germany (within the euro area). Somewhat ironically, one of the greatest beneficiaries of these influxes, namely the UK, has decided to leave, because the influx of migrants became politically unsustainable (or so the Leave campaign sold it as being). Brexit has proved us right, that the EU dis-integration process has begun. 

The optimists believe that without the UK a more cohesive union will emerge, and therefore the integration process will finally be able to proceed. This is likely to be an over-estimate of what will actually take place. The presence of the UK was the excuse all other reluctant countries were using not to proceed further with the integration process. Was the UK blocking the completion of the euro-area banking union with the adoption of EDIS (the European Deposit Insurance Scheme)? Of course not. It was Germany that was doing so.

With the rise of populist parties in all major EU countries(Germany, France, Italy, Spain, and Poland) and also in smaller countries (Hungary, Czech Republic, etc,), it was clear that, a soon as any severe crisis would arrive, it would constitute an existential threat to the EU. 

And, at that point, the EU would reveal whether or not it was up to the game, by completing its integration process, or else accelerate the ongoing dis-integration process. The shock has now arrived, of course, with the Coronavirus. We wondered whether the EU would finally face its “Hamilton moment” (i.e. finish its integration process) or, instead, its “Jefferson moment” (return to some form of Confederation, with limited sharing of sovereignty).

Facing the abyss, France and Germany have tried to come up with a proposal to mitigate the devastating effects of Covid and lockdowns on the economy of the continent. In an interview, German Finance Minister Olaf Scholz has called it Europe’s “Hamilton moment.” We wish that was true. The proposal has merits, and is in line with our previewfor how the EU would respond to the Covid crisis. 

But some of the details reveal that we are still quite far from any form of debt mutualisation, and the distrust that exists between the Northern “frugal four” (Finland, Denmark, Austria, Sweden) and the “profligate” Southern countries (Italy, Spain, Greece, etc.) remains high. We will see what the Commission proposal looks like on May 27, and what compromise the Council will be able to make in June and the following months. 

Our suspicion is that we will merely witness another round of the eternal “muddle through” that seems to characterise recent European history. To some extent, this would be better than the immediate collapse of the EU project, as any such collapse would have enormous economic, social and political costs. On the other hand, we doubt that any “more of the same” approach will equip Europe to succeed in the post-Covid world. 

by Brunello Rosa

18 May 2020

We have discussed several times how serious the Coronavirus-induced economic crisis is. The lockdown measures introduced by many countries to mitigate the spreading of the virus have created a collapse in economic activity, on the order of 20-40% on a quarterly basis. This could result in a fall in real GDP of about 7-10% in many developed economies, with a rebound next year that will be mushy and uneven at best. 

To mitigate the economic impact of Covid-19, a number of countries have adopted large stimulus packages consisting of fiscal expansion and monetary easing, in most cases in a coordinated fashion that closely resembles helicopter-money drops. Financial markets have, as usual, anticipated economic developments – equity prices collapsed around the world at the end of February/beginning of March, sending most of them into bear-market territory (-30% from their peak). Other segments of the market have given clear signs of dislocation. As discussed in our recent outlook, oil prices turned negative for the first time in history on April 20, as the collapse in global demand more than offset the cut to production that was decided upon by OPEC+ (including Russia) on April 12th.

Since the lows reached on March 23rd, equity markets have tried to rebound, but have done so with varying degrees of success. In the US, the S&P500 has recovered around half of the losses; it is now only down 11% year-to-date. The NASDAQ has managed an even more astonishing rebound, being at par year-to-date, thanks to the even more widespread use of technology during the lockdown. The Dow Jones, in contrast, which represent more traditional industries, is down 17% year-to-date.

In Europe, where the pandemic has led to harsher forms of lockdown (which are now being relaxed), the situation is less rosy, with the exceptions of Switzerland and Sweden. Equity markets remain down 25%-30% year-to-date. All these developments are in line with what we expected in our global outlook update.

As we previously discussed, a sustained recovery in market valuations could only occur when a durable solution (a vaccine or medication) to the healthcare crisis is in sight. Until then, market valuations will remain subject to downside risks. Nevertheless, as markets are leading indicators of economic activity, they will start to recover much sooner than the real economy. Conversely, the unemployment rate, which is a lagging indicator, will take much longer to normalise than economic activity in general. In the US, where unemployment insurance schemes and other similar automatic stabilisers are less widespread than in Europe, initial jobless claims reached 36 million in the first 7 week of the crisis. Non-farm payrolls dropped by 20.5mn in April, the largest monthly drop on record, with the country’s unemployment rate reaching 14.7%, up from the historically low 3.5% rate just a couple of months earlier.  

Public authorities are coming to the rescue: the Fed has just launched a Main Street program of credit easing. But the reality remains the same as it has been since the Global Financial Crisis: the liquidity injections by central banks tend to translate into asset price reflation, which mostly helps Wall Street, while other measures, even those akin to helicopter drops of money, leave Main Street in the doldrums. Again, this could be the result of the difference between leading and lagging indicators of economic activity, with equity prices rising much more quickly than unemployment rates in the wake of a serious crisis. But perhaps it could also signal the need to refocus the aim of the stimulus packages in the first place. 

by Brunello Rosa

11 May 2020

According to the most recent statistics, the UK is now third in the ranking of countries most affected by Coronavirus, after the US and Spain. It is second (after the US) in terms of number of deaths, with around 32,000 reported victims. Given the severity of the situation, the government, after initial hesitation, launched a complete lockdown of the country and its economy on March 23rd. Now, the government seems ready to relax some of these rules (for example, on daily exercise), while also tightening boarder controls (e.g. imposing a 14-day quarantine on anybody arriving in the UK). The central government – but not, for example, the devolved government in Scotland – is ready to move from the slogans “Stay Home/Protect the NHS/Save Lives” to “Stay Alert/Control The Virus/Save Lives”.

The impact of the pandemic and lockdown on the UK economy was recently estimated by the Bank of England, in the “illustrative scenario” described in its May Monetary Policy Report. The Bank estimated a 14% drop in the UK’s economic activity in 2020, followed by a V-shaped recovery of 15% in 2021. This estimate takes into consideration the overall policy response, namely a massive fiscal stimulus accompanied by a large monetary easing package, including rate cuts, increased QE and credit easing measures. The fiscal stimulus includes the innovative Job-Retention Scheme, by which the government will pay 80% of the salary of “furloughed” employees (up to GBP 2,500 a month) as long as their companies do not fire them, until June 30. The monetary stimulus includes a form of direct fiscal deficit, with the re-activation of the Bank’s “Ways and Means”, i.e. the Treasury account at the BoE.

While the pandemic and containment measures take their toll on the UK economy, the other major chapter of the UK’s political economy, Brexit negotiations, has re-started. As we have discussed in our previous analysis, the UK has no intention to seek another extension to the implementation period beyond December 2020. 

The EU now seems to have accepted this position, which initially was motivated by the UK’s intention not to repeat the experience of requesting multiple extensions as occurred during the prime ministership of Theresa May, which led to political chaos. But now there are two additional motivations, which we consider to be even stronger. 

First, as we explained in our analysis, “no deal” Brxit is the only logical conclusion of the approach brought forward by Johnson and his political side of the Conservative party, which won in a resounding way at the December 2019 elections. Second, the economic damage caused by the pandemic and the containment measures will easily mask any economic damage deriving from “no-deal” Brexit. The most visible aspect, namely travel restrictions and border controls, would be implemented anyway due to Covid. 

Thus for now the UK government has all the advantages of not seeking for an extension by June 30 while knowing that it can always get one at the very last minute). It will make “no deal” more likely, thereby strengthening its negotiating position at the table. And if a hard Brexit does occur, it is probably what hard-Brexiteers such as Boris Johnson and his chief advisor Dominic Cummings, Dominic Raab (currently foreign minister and senior secretary of state) and Michael Gove (in charge of Brexit planning) ultimately want. 

What happens if a no-deal, hard Brexit eventually occurs as a result of this tough negotiating approach? Well, the economic damage deriving from leaving the customs union and the single market without a deal, as well as increased border controls and customs checks, will likely be attributed by the government to the pandemic and the lockdown, rather than to the hard Brexit. The UK will also be free to respond to the additional economic shock by completely dis-aligning itself from the EU in terms of taxation, regulation, as well as product and labour standards. In the post-Covid world, where every country will try to do as much as possible just to remain afloat, the UK position might even not be perceived particularly at odds with that of other European countries, including those who will remain in the EU. 

by Brunello Rosa

4 May 2020

We have discussed the macroeconomic impact of Coronavirus in several recent columns and research pieces. It is clear that we have already started witnessing large falls in economic activity around the globe in Q1. In some countries, GDP had fallen already 4-5% on a quarterly basis, and the collapse of real GDP growth will be in double digits in Q2. As a result, oil prices have collapsed into negative territory for the first time ever. Unemployment rates are soaring everywhere, with the US having witnessed a 30mn rise in initial jobless claims in the last six weeks, wiping out the gains made over the past several years. 

Governments and central banks are coming to the rescue with large stimulus packages, but these will still struggle to reach small and medium sized enterprises (SMEs) and the self-employed, which will be decimated by the crisis. Helicopter money works only if money reaches every corner of the system, without remaining concentrated in the hands of a lucky few and without remaining concentrated in intermediary institutions such as banks. 

When economies and societies do re-open, nothing will be like it was before. We will have to live together with the virus for so many months, potentially for another year until a vaccine becomes available on a large scale for most of the global population. Until that time social distancing will remain the mantra in most work and business environments.

Teams might need to work on alternate days or weeks. Open-space offices will remain unfilled for the months to come. In the aviation industry, planes will fly half empty and airports will devote much larger spaces to passengers. 

In the hospitality industry, restaurants will have to find ways to serve food while complying with social distancing regulations, and hotels will remain half empty at best.    

In such an environment, what is the right strategy to adopt in order for your business to survive? Well, during the financial crisis, Richard Koo’s theory of “balance sheet recession” got a lot of attention. It was based on the fact that, in a financial crisis, private sector agents are trying to deleverage, and therefore the only entity able to increase its debts is the government. In such an environment, private sector agents switch from being profit-maximisers to become debt-minimizers, to regain financial viability.

In this crisis, unless private-sector agents receive grants from public authorities, they will need to take loans, which banks will offer at a very cheap rate and with favourable conditions as a result of central bank’s credit-easing measures. In this crisis, therefore, private-sector agents cannot afford to be debt-minimizers. Also, especially companies should forget about being profit maximisers, in order to avoid frustration and disappointment. In an environment such as the one described above, they will be forced to run at half-capacity at best and therefore they will surely suffer losses.

Since losses will come no matter what, the ideal business strategy to adopt is to minimize such losses, without regretting too much the lost revenues and profits. Most of those losses, especially in public services, will likely be subsidised by the government. In some cases, subsidization will not be possible, and so the aim should be to develop enough internal efficiencies to minimise future losses. The development of the various forms of remote working point exactly in that direction.  

by Brunello Rosa

27 April 2020

Last week, we analysed some of the ongoing issues that risk being overlooked as a result of the Covid-induced crisis. One of these issues was the impact of the crisis on carbon emissions. According to recent estimates, with 28 countries in the world having adopted full or partial lockdowns, the movements of a third of the world population are now enduring some form of restriction as a result of social distancing. Economic activity has been severely reduced because of this; the IMF is estimating a contraction of real GDP in 2020 of approximately 3% (but we expect it to be closer to 4%). Some sectors have completely shut down, and international travel, especially via planes, has collapsed. Statistics show that commercial air traffic has shrunk 41% below 2019 levels in the last two weeks of March. The situation since then has likely worsened even more, as more countries have adopted some form of lockdown.

As a result of this collapse in economic and travel activity, air pollution has collapsed, and greenhouse gas emissions have been dramatically reduced. According to the United Nations, since lockdowns and shutdowns begun, CO2 emissions have dropped by 6%. By the time the year ends, there will be an estimated 0.5%-2.2% reduction in CO2 emissions due to Covid (or even 5%, according to some experts), depending on the model adopted to predict the pick-up in economic activity in Q3 and Q4 2020. This could be the first reduction in global emissions since the 2008-2009 Global Financial Crisis. 

To some extent, the Covid-induced lockdowns have provided an unexpected, yet welcome, massive natural experiment as to the impact that a reduction on human economic activity can have on greenhouse gas emissions that are responsible for global warming (the rise in the earth’s temperature, estimated to be around 0.2˚ C every decade). This hopefully will resolve once and for all the vexata quaestio of whether global warming is caused by human activity or other unrelated factors. 

However, the UN warns, this temporary reduction in emissions will not stop climate change, which derives from the accumulation of the effects of many decades of human activity. Especially if the solution to this crisis will be the implementation of public infrastructure projects that have a significant environmental impact.  

While having gone silent in the last couple of months, climate change activists have gained a number of arguments in their favour. Not just on the impact that a reduction of economic activity might have on pollution and global warming, but also on the need for international coordination and cooperation to achieve that result. There is, however, another argument that will likely get traction. As the chart above shows, carbon emissions have increased in tandem with world population, which has risen from the 3 billion people of 1960 to the 7.6bn of 2018 (more than doubling in two generations). The UN estimates that there will be 11.2bn people in 2100, and if greenhouse gas emissions continue to be correlated with world population, the world’s temperature will rise well above any target being discussed in the various Conferences of The Parties (COP) rounds. 

Pandemics, if the virus is natural and not man made, may be partly a reaction to overpopulation (and therefore pollution). It is a clear signal the planet is sending that it may not have enough natural resources for all its inhabitants, at least not if resources are so unequally distributed. If the world does keep on increasing its human population without significantly changing its development model, pandemics will become more frequent and deadly in the future. 

If, then, we want to learn some lessons from the immense tragedy represented by Covid, they might include the following: 1) human beings are for the most part responsible for the catastrophes that befall them; 2) if the world’s development model does not radically change in favour of sustainability and renewable resources, extreme weather events will continue to affect the planet and pandemics will plague its human (and more generally, animal) population; and 3) only a coordinated and cooperative international approach can provide the solution to these historical issues. 

by Brunello Rosa

20 April 2020

We have lately been discussing four fundamental dimensions of COVID: healthcare, economics, policy, and market implications. On the healthcare front, advancements have been made that increase  intensive-care capacity (with field hospitals and other logistical arrangements) as well as testing, treatment and progress towards a vaccine. On the economics front, we have just released our latest estimates of the macroeconomic impact of lockdowns around the world. We have often also discussed the policy reaction (fiscal, monetary and regulatory) that will be needed to mitigate the effects of the macroeconomic impact and market implications of all these factors.  

Besides these four fundamental dimensions of COVID, we have also analysed what could be the long-term geopolitical implications of this crisis. Namely, China is set to gain the most from a strategic perspective, at the expense of the US, while the EU faces yet another existential crisis.

In this column, we want to discuss some of the events that are now occurring which risk being overlooked because of the pervasiveness of the news regarding the main dimensions of the crisis discussed above. We might call these the collateral effects of COVID. They too could have serious consequences, and perhaps even represent a turning point in the world’s history. 

On the one hand, as we have recently discussed in our in-depth analysis, there is the progress that is still being made by various countries in technologies such as artificial intelligence, which could provide a massive geo-strategic advantage to those who master them first. Russia, for example, is certainly using this period to make gains vis-a-vis its international competitors, by making large use of AI, and not just to find a cure for COVID-19. Russia is certainly not alone in this game, but it has a historical head-start over most other countries where cyberwarfare is concerned.  

On the other hand, the US is about to enter one of its more turbulent periods in recent history.  The US is already the country in the world with the largest number of confirmed cases and deaths, and yet partisanship regarding how to face this pandemic still prevails, with science being regularly questioned by populist political leaders and media. The US will soon have to face an election in a time of the pandemic,  the result of which (as we discussed in our recent analysis) is now too-close-to call. There are those who suggest that if Trump were to lose by a small margin and the vote were to be contested, he would not accept the verdict of the Supreme Court, like Al Gore did when he run and lost against George W. Bush in 2000. The requests on Twitter made by President Trump to “LIBERATE” a number of states that are being governed by Democratic governors who are imposing COVID-related restrictions, and the gathering of armed militias to protest those restrictions, do not bode well for the future. 

Around the world, authoritarian leaders are using the excuse of lockdowns to increase their grip on power and leave even less freedom to opposition parties and the press. This is happening even in Europe, within the European Union, ostensibly the most advanced defender of civil and political liberties in the world, where Hungary’s PM Victor Orban has created a de-facto dictatorship.

On a larger scale, the fight against climate change has gone incredibly silent in the last few weeks. Clearly there is an even more imminent threat to deal with, but at the same time, the arguments made by those fighting against climate change have been made even stronger by the COVID crisis. The virus, if natural and not man made, is certainly a reaction of overpopulation and pollution. With lockdowns imposed in most countries, the world has just carried out its largest natural experiment as to how pollution can be greatly contained if human activities are drastically reduced. At the same time, the opponents of those advocating against climate change will say that the top priority now is re-starting the world’s economic engine, rather than worrying about the side effects such as pollution and climate change.

All these example show that even as we follow the news about the COVID crisis, we should not lose sight of what else is happening in the world, which could have long-lasting consequences that will become apparent only when the current emergency is ended. 

by Brunello Rosa

14 April 2020

As we discussed last week, the impact on economic activity and markets from Covid depends crucially on medical advancements made in the fight against the virus. When progress on the medical front is considered sufficient by market participants, it is likely that risky asset prices will then start to recover (certainly, they will do so before economic activity itself stabilises). The impact of the virus on economic activity could also become smaller if enough advancement is made on the medical front. 

While China is facing its second mini-wave of contagion, deriving mostly from people returning home from abroad, there are reports that Spain is tentatively starting to re-open some of its non-essential activities, such as factories and some offices. Italy has started to plan a gradual re-opening, aimed at May 4th, and a task force led by former Vodafone CEO Vittorio Colao has been appointed by the government to plan a gradual re-opening of the economy. An undersecretary of Conte’s government even ventured to say that Italy’s beaches could be open this summer, if social distancing measures are in place. 

The situation is very different in the UK, the US and Sweden, which have been late to adopt social distancing measures, and are still in the fast-accelerating part of the contagion curve. In particular, in the UK, the country has been following a path not too dissimilar from that of Italy, and its Prime Minister Boris Johnson admitted that he could have died of Covid-19 during his stay in the hospital. In the US, the scenes of public burials in New York has shocked people around the globe. In Sweden, PM Stefan Lofven had to apologise for being too slow and timid in adopting social distancing measures. 

However, some glimmers of hope are starting to emerge from the medical front, which, as we said last week, consists of four sub-fronts. On the increase in intensive-care capacity, a lot of progress has been made worldwide, with the construction of field hospitals. This should help manage the expected increase in the number in patients admitted to hospitals in the most-hit countries.

On testing, the availability of antibody tests (which can tell if somebody had been infected and has developed some form of immunity to the virus) has increased massively, and the Lombardy region, one of the areas most affected by the epidemic, has stated that soon a large-scale distribution of what will be considered “Covid-19 health passports” will begin. On the other two medical sub-fronts, namely  treatment and vaccine, plenty of progress has been made as well.

As to a possible cure for the virus, doctors have identified the three phases of infection. Against the first phase, when the virus starts to attack cells, at least two medicines have proved to be effective, Cloroquineand L-Asparaginase. If a virus still manages to infect the body, anti-inflammatory medicines (such as steroids that reduce inflammation and the immune response) can reduce the impact on the affected person. 

In the third phase, when infection becomes serious, the virus causes an over-production of antibodies that clog the lungs and create small thrombus that start circulating throughout the body, causing multiple organ failure and eventually death. Against this, a group of doctors in various hospitals in Italy have started to test the efficacy of a traditional anticoagulant, the heparin, which prevents the formation of thrombus. Initial clinical tests show that this cure is effective and, if heparin is given early enough, patients might not need to be hospitalised. From this mix of cures, it is likely that very soon a clinical protocol to treat patients in the various phases of the disease will become standardised, thus reducing the need for intensive-care units. The good news is that most of these medicines are quite common and therefore not very expensive. 

On the final front, the vaccine, good progress has also being made. Besides the progress that has been made in Pittsburgh, which we mentioned last week, another team of researchers, based in Italy in collaboration with Oxford University, has found a methodology that will be tested by the end of the month, which could result in a vaccine being ready by September (in small samples). 

All this is to say that much effort is being made to reduce the impact of the virus on the health of people and on economic activity. While we need to remain vigilant against second and third waves of the virus (which could be more deadly than the first), three strains of which have already been identified, it is encouraging that some progress is being made on the medical front.  

by Brunello Rosa

6 April 2020

The Covid pandemic has now led to more than a 1.2 million people being infected around the world, and 68,000 confirmed deaths. It is now clearly understood that the economic impact of this crisis will be far worse than was the 2008-09 financial crisis, and maybe as bad as that of the Great Depression in the 1930s. It could, potentially, be even worse than the Great Depression (as Nouriel Roubini calls it, a Greater Depression). 

After initial hesitations, in particular in the US, UK, Brazil and Sweden, the pandemic has now generated a policy response that is broadly homogeneous around the globe. From a healthcare perspective, partial or total lockdowns have been imposed by several countries, with severe restrictions that can be slightly less draconian in those countries which have a population historically used to self-discipline, such as the UK. Of the largest countries, only the US is still reluctant to adopt serious measures of suppression, preferring forms of light mitigation instead. This is a mistake that will cost dearly down the line. 

In terms of fiscal policy, virtually every economy has launched schemes aimed at guaranteeing liquidity and credit to large, medium and small enterprises, and fiscal support to workers, without much distinction between protected salaried workers and unprotected self-employed ones. In terms of monetary policy, almost all central banks in the world have adopted a combination of cuts to policy rates, increasing asset purchases, funding for lending schemes, longer-term refinancing operations against wider collateral, easier access to emergency lending, FX intervention and swap lines. Regulators have relaxed capital and liquidity requirements for financial institutionsto increase their lending capacity.

Despite all this, stock prices in equity markets, sovereign yields of reserve currency countries and oil prices continue to fall. Why? The answer is simple: there is still no light at the end of the COVID-19 tunnel. Even if policy makers throw the kitchen sink at the crisis, they will not resolve the underlying issue, which is the containment of (or the cure for) the virus. 

Only medical experts and scientists, in this occasion, hold the key to solving the crisis. The measures introduced so far and discussed above only aim at buying time for scientists to find a solution. Initially, they are intended to flatten the curve of contagion, reduce the influx of patients into hospitals requiring expensive intensive-care units (ICUs), and increase their ICU capacity, perhaps by building field hospitals.   

Following these necessary initial measures, progress needs to be made in the other three directions that will lead to the eventual “victory” over the virus. First, testing needs to become available on a much larger scale, in order to trace the diffusion of contagion. And, more so than the current antigenic testing (which tells if somebody is currently infected), the development of reliable forms of antibody tests will be crucial, to easily determine who had been infected and has developed immunity (even if such immunity is only temporary) and could therefore – for example – return to work. Secondly, if a treatment is found that alleviates the symptoms and reduces the need for ICUs, this would mark a major change in people’s perceptions of the virus. It will help people calculate the risk of living in a world where the virus is still prevalent, which is likely to become necessary at some point unless we are willing to keep the world shut for the next 18 months. 

Finally, there is the goal of developing a vaccine that would allow people to develop antibodies and return to work. On this front, there might be some promising progress that could speed up the process compared to the 12-18 months currently being estimated. Even still, we are talking about a timeline of several months before the fastest vaccine could possibly become available to millions of people.  

Only when some breakthrough on a combination of these fronts occurs will it become possible to realistically say that there is some light that can be seen at the end of the tunnel. At that point, equity prices will find credible reason to rebound. The bad news is that we do not know when these breakthroughs might occur. The good news is that they could happen at any point in time during the next few weeks.  

by Brunello Rosa

30 March 2020

In our column of March 16th, titled “The World Is Likely To Be Radically Different After The Coronavirus Crisis” we mentioned that the Coronavirus is posing an existential threat to the survival of the EU. In this column, we want to further elaborate on this issue, following the EU Council meeting on March 26, in which the heads of state and governments failed to reach a deal for a common strategy to fight the crisis.

The underlying principle behind the EU integration process is the solidarity that member states should display towards one another on all matters of common interest, after centuries of inter-European conflict. For this reason, the first embryo of the EU was the European Coal and Steel Community, coal and steel representing the key ingredients for the economic recovery in the post-War period. Once solidarity ceases to exist, there is no reason for the Union to exist either. In spite of the initial, delusional hope that COVID-19 was an asymmetric shock to Italy rather than a generalized crisis across the region, and could therefore be addressed by the activation of article 122.2 of the EU Treaty (i.e. grants to the country “seriously threatened with severe difficulties caused by … exceptional circumstances beyond its control”), it is now clear that is a symmetric shock to every country of the EU. 

This means that the EU as a whole should react to it, with common instruments, rather than by simply adopting a coordinated approach of national policies by individual member states. Instead, so far national selfishness has prevailed, and countries have reacted by adopting a series of policies based on their individual circumstances. For example, at the fiscal level, Germany has announced a plan of EUR 550bn of fiscal easing (of which EUR 156 will be fresh expenditures), France a EUR 300bn plan, and Italy, given its more stringent budget constraints, only a first EUR 25bn plan followed by another EUR 25bn likely to be announced in April. Virtually all countries have re-instated national borders and suspended the Schengen agreement.

At the EU level, there has thus far been only a partial and temporary suspension of the Growth and Stability Pact (GSP) and an easing of the discipline regarding state aid to private-sector companies. Even the ECB was initially reluctant to engage in its mandatory spread-compression activities, until finally the EUR 750bn PEPP was launched, with the inclusion of Greece and the suspension of the issuer limits. But this is still too little compared to what the EU could and should do to face the existential crisis before it. 

With Brexit underway, and the UK initially threatening to deviate from the continental practices of social distancing to follow a chimeric and flawed herd immunity approach; with Schengen and the GSP suspended; with every country following its own approach to COVID, from para-military lockdowns (in Italy, for example) to minimal social distancing rules (e.g. in Sweden), the risk is that re-converging when the crisis is finished will become virtually impossible, as every country will find it more convenient to pursue its national strategies and interests. A country might, for example, bitterly and understandably decline to pursue European reintegration because it felt that it was neglected during the crisis.

Take Italy, for example. In 2011-12 Italy was brought to the verge of default because of the slow and flawed response (by moral hazard considerations) from the EU/EZ to the Greek crisis. Italy, which participated in the rescue packages for Greece, Ireland, Portugal and Spain, came under speculative attack because it was perceived as being part of the PIIGS grouping of economies. Only Draghi’s “whatever it takes” pledge and the consequent OMT avoided the disaster. In 2015, during the migrant crisis, Italy was then left alone facing the arrival of ships landing on the southern shores of Europe. In 2020, after the symmetric exogenous shock deriving from COVID, the implicit message from the EU was: “deal with it by yourself, we’ll be lenient on your fiscal position, ex-post.” It is not clear where solidarity is in all this, and we should not be surprised if, at the end of the crisis, the levels of EU-scepticism will be at historical highs. Other countries are in similar positions, and if the EU fails to rise to the historical task it is now facing, it might end up being the largest, institutional victim of Coronavirus. 

So, while Merkel and Von Der Leyen declared their opposition to Eurobonds/Coronabonds being used  to finance a pan-European recovery plan, the Eurogroup has been tasked with coming up with technical proposal on the feasibility of risk-sharing instruments. Hopefully, it will come up with some serious proposals in the next couple of weeks, and these approaches will be adopted by the EU Council. But other roads are possible, such as the possibility of activating ESM loans with virtually zero interest rates and null or very limited conditionality. That, in turn, could open up the possibility of using the OMT to fight unwarranted widening of sovereign yield spreads within the EZ. 

by Brunello Rosa

23 March 2020

We have discussed Coronavirus in a series of columns in our weekly Viewsletter this year. Discussing the virus is inevitable, considering the importance the COVID-19 will have on all aspects of life for a large part of the world population – with its health, economic conditions and financial repercussions. Our first column on COVID dates from February 3rd, when China was starting to impose some of its most draconian measures while all other countries were ignoring the risk or happily living in denial. On that occasion we warned that “Coronavirus Poses a Downside Risk To The Global Economy.”

One month later, on March 2nd, we commented on how financial markets had finally caught up with reality of the virus, saying that markets “Belatedly Correct on Coronavirus Concerns.” The week after that, we discussed how central banks had tried to come to the rescue with more of the same “medicine” (i.e. rate cuts and a limited increase in asset purchases). Finally, last week, we took a longer-term view that the world will look radically different a year from now. 

This week, we are discussing how central banks and governments have finally realised the magnitude of the shock and the therapy needed to mitigate its impact. As we discussed in Part 1 of our Global Outlook Update, we now expect the global economy to experience a global recession in 2020, as our baseline scenario. In downside scenarios, the economic contraction could be much more pronounced and prolonged. As most countries are now realizing what was, in our opinion, self-evident, namely  that Italy has simply been a leading indicator of what could happen if they do not contain the spreading of the virus early on, the policy decisions deriving from this “epiphany” are now finally starting to appear on the horizon.

As we discuss in Part 2 of the Global Outlook Update, most countries are now adopting monetary and fiscal expansion measures to limit the damage to the economy deriving from the draconian measures adopted to contain the virus. These draconian measures which include the partial or total lockdown of the country, suspension of all international travel, re-instatement of borders, even within the EU with the suspension of Schengen, etc. In the US, the Fed has brought its policy rate to zero and re-started QE, and the government has presented to the Senate a USD 1.6tn fiscal easing package, potentially including forms of cash directly sent to households. The UK government has announced a GBP 330bn fiscal easing package, while the BOE slashed rates to virtually zero and re-started QE. In France, President Macron has announced a EUR 300bn fiscal package, while Germany has finally thrown its ridiculous “schwarz null” policy out of the window and pledged EUR 550bn of fiscal stimulus (including loans and credit guarantees), of which EUR 156bn will be fresh money expenditures. The ECB, following the initial mishap by President Lagarde, has staged its “Whatever it Takes – 2” moment, launching its new PEPP plan of EUR 750bn of asset purchases. 

The next stage in this process is increased coordination between the monetary and fiscal responses, both of which are needed for the overall response to the crisis to be effective. This will likely translate into forms of direct or indirect debt and deficit monetisation, which has been variously labelled as People’s QE, MMT or helicopter drops of money. It is with some relief that we finally see these “helicopters” taking off to fight the effects of COVID on the economy and financial markets.

by Brunello Rosa

16 March 2020

Now that the new Coronavirus (COVID-19) has officially been declared a pandemic by the WHO, an increasing number of countries are adopting measures to counter its spreading. Financial markets have collapsed as a result; it is clear that we are facing a serious health, economic and financial crisis. This is likely to be more serious than that in 2008-09, which was a banking, demand, and confidence crisis. This is a demand, supply, and confidence crisis, in which banks have not yet played a major role. In 2008-09 there was the element of uncertainty as to how low housing and asset prices would fall before finding a floor. Today, in contrast, there is a much larger element of uncertainty: How long will this crisis last? 

In fact, the re-opening of economies even after the number of new cases is dropped to zero will remain gradual at best. Until a vaccine becomes available, the virus can always come back and force the authorities to close their economies all over again to stop the contagion. So, let us make the assumption that not until 12-18 months from now, if a vaccine then becomes available to everybody, will the end of the health emergency occur. For the sake of the argument, let us assume that we will be able to expedite the production of a vaccine to only 12 months from now. The world would then be in some form of emergency until Q1 2021.

What will the world be like that will emerge from this crisis? We believe that the world in 2021 will be radically different from that which exists today.

In China , there will be two opposing forces. On the one hand, there will be the conviction that the regime was able to contain the virus in three months of very hard work, which in turn gave much of the rest of the world the template to use when attempting to contain the virus themselves. The regime could use this to strengthen its grip on society, and on any form of dissent, or against any emerging appreciation for Western values such as “privacy”. On the other hand, the regime will at the same time be blamed for hiding the real nature of this pandemic for too long, causing the damage at global level that now plainly exists. Chinese society might also have to rethink some of its millennial traditions (including food and hygienic standards) that make China the origin of virtually every new flu strain. Overall, we believe China will come out stronger and even more modernised from this experience, even if its regime might need to make further strides to regain legitimacy and trust among the wider populace. 

On the other side of the Pacific, there is the US, where the political leadership is held by a person, President Trump, who embodies of the polar-opposite attitude that led the Chinese to a rapid victory against the virus: indecisiveness, mis-representation of facts, open criticism of scientifically-proven theories in favour of his gut feelings, under-reaction followed by over-reactions.  There is enough to make many people re-think the idea that a large and complex country like the US can be governed by virtually anybody so long as the “deep state” and its institutions are alive and well. Given its initial mistakes, the US will take much longer to rein in the disease. Perhaps the worst economic impact will be felt just before the November election, and therefore COVID could easily cost Trump the re-election. But the country will be shaken in its preference for relatively low personal and corporation tax levels at the cost of many public goods such as a universal healthcare system and good-quality education. The US has lost its supremacy in many domains versus China; this crisis will further shake its position as the world’s leading country.

In between these two countries, there is the EU, which will face its most serious existential crisis since its foundation. The uncoordinated health and fiscal response to the virus, plus the arbitrary and unilateral closures of the borders (i.e. suspending the Schengen agreement) have, once again, shown the fragility of the European construct and the possibility of its collapse. The only truly pan-European institution has missed this opportunity to show leadership, as it did during its previous existential crisis, the Euro crisis, in 2012. The package of measures adopted last week was borderline adequate given the stage of the threat, considering that the package could be further expanded in coming months. But the ECB cannot afford mishaps such as that which was made by President Lagarde, when she said that “it’s not the ECB’s job to close the spreads within the EZ sovereign bond yields.” In the absence of Eurobonds or EZ safe assets, it is precisely the ECB’s job to ensure that the spreads remain compressed, in order to ensure the smooth transmission of monetary policy. Additionally, the ECB has a facility (OMT) specifically designed to close widening spreads unwarranted by market fundamentals. In addition, because most countries will move into forms of fiscal-monetary coordination, the EU, with its 27 fiscal regimes and several central banks, will have much harder time than the ECB would at implementing a similarly coordinated response to the crisis. 

In conclusion, we believe that all the three main areas of the world will face serious crises of political legitimacy and, in the case of the EU, existential threats. Other countries and regimes will equally come under severe stress and could collapse as a result of this crisis. The rankings of countries at the global level will change drastically after this crisis, in many dimensions. We should prepare to see debt/GDP ratios approaching 150-200%, as often occurs during wartime. Global supply chains will be further disrupted; the tendency towards de-globalisation will be reinforced. Returning to the “new normal” will be another enormous task of world leaders in 2021; at least, for those leaders who will have politically survived.   

by Brunello Rosa

9 March 2020

The latest news from the COVID-19 front is a mixed bag. In China, following the draconian measures of containment the country adopted during the last few weeks, the official number of new cases is close to zero. A number of existing cases still need to be resolved, but there are not new infections occurring that would aggravate the situation. In the rest of the world, however, the situation is starting to become increasingly bad. In Italy, which has been the country with the second highest number fatalities (almost 370), the daily percentage increase of new cases is still around 20-25%, which means that the number of reported cases doubles every 4-5 days. Thus the diffusion of the infection is still in its exponential phase. And the number of cases is increasing in other countries too, including Germany and the UK and, of course, the US. 

Albeit slowly, authorities in Germany, the UKand at EU level are awakening to the fact that COVID-19 is not going to remain a phenomenon limited to Italy, a conviction some European leaders have deluded themselves with for too long. This means that, in time, a larger response will be put in place. In the US, it seems that we are still in the delusional phase in which COVID-19 will remain primarily limited to China and Europe, with only a limited spread in the US. The response has therefore been limited and insufficient so far. The number of swab tests being carried out is still ridiculously low, and the official number of infected people is being kept artificially low by the fact that they are not being detected. 

But the story of this virus always shows the same news cycle. 

Initially, politicians delude themselves that the problem will remain limited to other countries. As soon as the first person dies in that country as a result of COVID-19, this delusion is no longer tenable, and so the initial timid admission and response occurs. When the number of deaths increases, one can easily infer the total number of infected people by knowing that the mortality rate at global level is around 3.4%. When the number of cases reaches the thousands, the response then becomes forceful. In Italy, the entire region of Lombardy has been quarantined, as have other provinces from neighbouring regions: people cannot get in or out. 

As the disease spreads, the economic damage worsens. In our upcoming updated outlook, we will show how we expect global growth to be closer to 2% in 2020 than 3%. This means that in some countries, such as Italy and Japan, there will be a recession this year. Other countries could be equally badly affected – Germany might also fall into a recession, and US growth is likely to be around half of what was expected back in December. To prevent the economic downturn from becoming too large, policy makers are coming to the rescue. Fiscal authorities are trying to design targeted relief plans, in particular to support solvent but illiquid small and medium sized enterprises. 

Central banks can also act faster to support market sentiment. A number of them have cut rates in the last few days: the Federal Reserve by 50bps to 1.00-1.25% (intra-meeting), the RBA by 25bps to 0.50%, the BoC by 50bps to 1.25%. Elsewhere, the central banks of Hong Kong and Malaysia cut their interest rates by 50bps (to 1.50%) and by 25bps (to 2.50%), respectively. These interventions are necessary to support market sentiment but will do little to solve the problem generally. The market understands all this, and therefore the selloff in equities continues. Equities will continue to adjust until market participants believe that the virus has been successfully contained at the global level. Even in the best-case scenario, this could take at least a couple of quarters. If the US delays its response to the virus in order to keep the economy strong during an electoral year, the process will be severely delayed, with the result being that immense damage to global health and economic activity could ensue.  

by Brunello Rosa

2 March 2020

At very long last, financial markets caught up with the reality of the coronavirus, selling off last week in the worst market performance since the Global Financial Crisis of 2008. As the Financial Times reported, “mounting concerns at the rapid spread of the coronavirus caused one of the quickest market corrections in the benchmark US S&P 500 since the Great Depression in the 1930s.”
As we have written in our in-depth report on the subject, market participants are finally realising the impact that COVID-19 could have on the economic performance of the countries that have been most affected by the disease. In our column on the potential impact of COVID-19 (which we published a month ago already), we warned that the downside risks posed to the global economy by the public reaction to the virus could be huge, possibly greater even than the virus itself. In effect, last week market participants staged a panic reaction to the news coming from Italy, where entire cities were quarantined in the country’s northern region, which is the industrial powerhouse of the country, with  Milan, the financial capital of the country, being the epicentre.
Since then, the situation has not improved: the number of infected people and fatalities worldwide have risen (albeit at a slower rate than in previous weeks), surpassing 85,000 and 3,000 respectively. At the same time, the number of people who have recovered from the disease has also increased, surpassing 42,000. Most importantly, the US has suffered its first fatality from COVID-19 (near Seattle). This could mark the beginning of a new phase in the crisis. In fact, as we have already said, unless the pathogen mutates suddenly in coming months, the mortality rate will remain relatively low, around 2% globally of those who become infected with it.
Nevertheless, the economic impact of the virus will derive from the reaction of governments to the news about it. No politician wants to be blamed for not having taken sufficient action in response to the virus. The first reaction from the US was the suspension of certain flights from the US to Northern Italy. As the number of cases and deaths  increases in the US, however, so too will the escalation in the counter-measures the government takes. The economic impact of severe counter-measures in the US would take the economic impact of COVID-19 to a different order of magnitude, and would have a global economic impact. A global recession in 2020 is now becoming a real possibility.    
The countries that have experienced the largest number of cases of infection show that the economic impact of the virus could be large, and might not necessarily be V-shaped as had been optimistically assumed by some commentators until just a few days ago. In China, the manufacturing PMI has collapsed to 35.7 in February, down from 50 in January, marking a new all-time low. Any figure below 42 in China signals an outright contraction in activity. The GDP in China, Japan, South Korea and Italy will contract sharply in Q1, and perhaps also in Q2. Fiscal packages to ease the sharp fall in economic activity are in the process of being approved in those countries. The latest is the EUR 3.6bn package announced by Italy on Sunday. These measures will help to a certain extent, but ultimately will not be able to achieve much. In particular, monetary policy, which will likely become more expansionary at the global level pretty soon, is likely to prove impotent against a supply-side shock.  
Considering all of this, it is clear that market participants should brace themselves for more volatility and corrections in the weeks and months ahead. The impact of Coronavirus on global economic activity will be large and persistent. The policy response will be slower, smaller and less effective than expected. This will necessarily have to be reflected in the valuation of risky asset classes. Fasten your seatbelts. 

by Brunello Rosa

24 February 2020

After entering the Democratic primary late, Michael Bloomberg is trying to establish himself as the only Democratic candidate who can defeat Trump in November. His strategy might prove to have been well-calculated. By not entering the race before the caucuses in Iowa and New Hampshire were held, he knew that by the time Super Tuesday takes place on 3 March one of the left-wing contenders (either Bernie Sanders or Elizabeth Warren) would be ahead in the game – an that would scare the median voter, financial markets, and also the Democratic leadership into preferring a candidate like himself. The result of the latest primary election, in Nevada, where Sanders once again finished ahead of centrist candidates such as Joe Biden and Pete Buttigieg, confirmed this trend (which can also be seen at a national level, according to recent polls), and thereby the validity of Bloomberg’s strategy.
Michael Bloomberg might have thought that, after scaring markets and centrist voters with the advancement of radical left-wing candidates (notably, of Bernie Sanders, who self-defines himself as a socialist), the democratic leadership would come to him, begging him to unify the party and lead it in the race against Trump in November. However, things might not work out as Bloomberg may have planned. In the first televised debate in which he appeared against the other Democratic candidates, Bloomberg was frontally attacked by the left-wing contenders, in particular by Elizabeth Warren. He did not come across as particularly friendly in this exchange. A highly curated video clip of the debate, in which Bloomberg asks the other candidates who else has founded a successful business, did not do him great credit either. While he had a point, since he is indeed the only one among the remaining Democratic candidates with that achievement, the entire scene lasted no more than a couple of seconds on live television, while the video made it look much more dramatic than it had been in reality.
Also troubling the Bloomberg campaign is a series of NDAs signed by women who were allegedly mis-treated when working at Bloomberg LLC.. So, even if Bloomberg may be the only candidate who can defeat Trump in November, he still faces an uphill battle to win the Democratic nomination.   In particular, Bloomberg will have to mobilize a portion of the Democratic electorate – African-Americans, other ethnic minorities, women – that is essential to win the nomination and, eventually,  the general election. Some fights with the black community when he was mayor of New York will not help him in this battle. Additionally, his profile might not be particularly attractive to this key portion of the Democratic electorate. While being a truly self-made man (unlike Donald Trump, who inherited his fortune from his father), Bloomberg is still the sort of New York-style billionaire who does not necessarily attract the sympathy of minorities and other traditional segments of the Democratic electorate. Also, the story of the women-related NDAs risks sticking to him much more than to Trump, who the electorate seems willing to forgive almost anything. (Certainly, the number and depth of allegations against Trump is much larger than those against Bloomberg).
Bloomberg, therefore, might not be the white knight he was presumably hoping to become. The race for the Democratic nomination remains open. The simple truth is that the Democratic party has not been able thus far to converge towards a candidate who can truly represent a credible threat to Trump in the coming general election. The president will present as victories his trade and tech wars with China, his hard-line on Iran, and other high-profile battles that could ultimately damage the international reputation of the US and its economy. His electorate might accept this narrative, securing his re-election in November. If the Dems want to avoid this, they better start getting their act together, and fast.  

by Brunello Rosa

17 February 2020

During the weekend, the annual Munich Security Conference was held in the capital of Bavaria, Germany’s richest state. Media outlets extensively reported on the key proceedings of the conference, which this year focused on the concept of “Westlessness”; i.e., on whether the world has become less Western. This is a concept they also studied in depth in their annual report. As long as the “West” is defined by the alliance between North America and Europe, along with the key additions of Australia and New Zealand (part of the so-called Five Eyes), clearly the last few years have observed a marked deterioration in this relationship, and in particular of NATO, the military alliance underpinning it. 

US Secretary of State Mike Pompeo came to Munich to reassure those present that NATO is alive and well, and that it is ready to deploy its benefits to its constituent countries. Pompeo specifically said that he was “happy to report that the death of the transatlantic alliance is grossly exaggerated. The West is winning, and we’re winning together.” However, only in November 2019, Pompeo himself warned that NATO was risking extinction unless it adapted itself to reality. This happened at the same time as French President Emmanuel Macron was reported as saying that NATO was brain-dead. So, what’s the current state of the transatlantic alliance, in reality?

It is true that NATO is still alive, but its cohesion has been severely tested recently. Trump has just approved a series of tariffs on the Europeans, following the WTO ruling on EU’s aid to Airbus in that company’s long dispute with Boeing. (Italy, which does not belong to the Airbus consortium, got exempted from these tariffs, thanks to their own successful bilateral negotiations). Other tariffs aimed at the auto sector are also being considered by the Trump administration at the moment, after being delayed by six months in May 2019. 

In a few months, when the WTO will likely rule in favour of Airbus and the Europeans will be able to impose retaliatory tariffs on the US, we might be at the beginning of another tit-for-tat trade war, similar to that we have been observing between US and China in the last three years. 

Within Europe, the situation is, at best, fluid. The UK has just left the EU, imposing a severe level of damage onto the geopolitical standing of the continental bloc, as discussed by John Hulsman in his recent analysis. PM Johnson is now mostly committed to establish his leadership within Whitehall, as the recent reshuffling of his government proves. What is left of the EU is in flux. In Germany, the decision by Annegret Kramp Karrembauer not to run for Chancellor at the next federal election has completely ruined Angela Merkel’s succession plans. As we discussed in our analysis of the German political scene, under certain circumstances, this might eventually lead to a desirable outcome, for example a Green-Black coalition. On the other hand, it might make Germany even more inward-looking and undecided as to how to exert its leadership on the continent. And Germany is absolutely needed by French President Macron if he wants any of his grandiose plans for the future of Europe to ever become a reality. As we discussed in our recent trip report, both the social and political opposition to Macron are weak or weakening, paving the way to his re-election in 2022 (bar a global economic crisis occurring in the meantime). But without its German dance partner, there is very little France will be able to do. 

So, the West might be still in the position of taking on China, weakened by the impact that the Coronavirus might have on the Chinese economy and on the legitimacy of its regime. But the West needs to find a new sense of unity if it wants to win the battle for the geo-strategic hegemony of the future. At a time when China is trying to reach out to the Europeans, to convince them to break ranks with their historical US ally, and with Trump not hiding his distaste for the EU concept, this might be easier said than done.

by Brunello Rosa

10 February 2020

Two crucial regional elections took place in Italy a couple of weeks ago, one in Emilia-Romagna (in northern Italy) and the other in Calabria (in southern Italy). Lega’s leader Matteo Salvini greatly increased the significance of the election in Emilia-Romagna, a region that has been a stronghold of the Democratic Party (PD), making the election appear, in effect, as a referendum on the government. As we discussed in our in-depth analysis following the election, if Lega’s candidate Lucia Borgonzoni had won with a relatively ample margin, this could have led to the resignation of Nicola Zingaretti from the leadership of the PD. Since Di Maio had already resigned from his national leadership role in the Five Star Movement, a resignation by Zingaretti could have led to the collapse of the government altogether. Since Borgonzoni did not win, however, and since her opponent, the incumbent leader Stefano Bonaccini, won with a 7-point difference in the regional election, this scenario did not happen. So, Giuseppe Conte and his government could relax for the moment. Still, this respite might prove short-lived. 

In fact, theoretically speaking, if the governing coalition manages to survive the additional round of elections in May/June 2020, the possibility for this parliament to last until 2022 (after the election of the new president), could be quite high, either with the current governing coalition or with a slightly different one. Elections in 2020 would become extremely unlikely and, if the coalition were to stick together for six more months from January to June 2021, then in September President Mattarella would lose his power to dissolve parliament. Thus the only theoretical window for an election would be between March and June 2021. 

In reality, things might prove more complicated than this. Matteo Renzi is restless in his attempt to force a change of the Prime Minister, and is now using a parliamentary battle over the reform to the statute of limitations in criminal trials to re-launch his assault. An already fragile majority is vulnerable to defections in parliament, and the possible support from MPs from other parties (for example, from Forza Italia), would not be reassuring for PM Giuseppe Conte. He could become hostage to all sorts of vetoes. If MPs from a new party were to vote in favour of the government in a confidence vote, President Mattarella might call Conte for an update on parliamentary developments, and send him back to the Chambers for a new confidence vote, to re-assess the “perimeter” of the coalition supporting the government. The reality is that the Italian government remains fragile, and could collapse as a result of a parliamentary incident at any time.  

What is the centre-right doing during all this? Salvini’s Lega continues to poll above 30%, and Meloni’s Fratelli D’Italia has now reached 10% in the polls, well ahead of Berlusconi’s Forza Italia, which now struggles to get to 6%. Altogether, the centre-right coalition polls around 50%. Salvini’s popularity remains very high, but not as high as it was previously. The belief in his infallibility has been now severely hit by two consecutive mistakes: his decision to make the Conte-1 government collapse in August 2019, and his decision to transform the regional election in Emilia-Romagna into a referendum on the government. He will soon face a vote in the Senate, which will decide whether or not he will have to stand a trial for “kidnapping” the migrants of the Gregoretti ship. And he will probably lose the constitutional referendum over making a cut to the number of MPs, which will take place in March. Investigations into “Moscow-gate” are continuing, meanwhile. 

Can Salvini stage a comeback through all this, and so ascend to power in the coming months or years? Theoretically speaking, yes, he can, especially if the governing coalition proves incapable of sticking together. Polls suggest that Italians still seem inclined to give Salvini a chance to prove himself as PM. But the biggest obstacle to his final ascent to power is… himself. The recent re-organisation of Salvini’s party shows that he might have understood the underlying problem that has led him to all the mistakes mentioned above. During his period in government, when he was gaining popularity, he managed to antagonise the US allies (his trip to Washington was reportedly a disaster), the Europeans (his preferred target), the Chinese (by not signing the MoU on the silk-road) and the Russians (with Moscow-gate). In addition, he antagonised the vast majority of the global economic and financial establishment, which fears a breakup of the Eurozone following a potential decision by Italy, led by Salvini, to leave the euro area. It will take time for Salvini to gain credibility within all these powerful circles. 

So, somewhat ironically, the centre-right led by Salvini needs time to become a credible governing coalition. And the centre-left hopes to stay in power for as long as possible. These two converging tendencies might keep this parliament alive for longer than is currently believed, even if it remains true that an accident could occur that would bring down the government at any time.    

by Brunello Rosa

3 February 2020

In the last couple of weeks, the world has witnessed the outbreak of the Coronavirus (2019-nCov) infection, and its global diffusion. According to the most recent statistics, there are 14,500 people reported as infected in Asia, more than 9000 of whom are in China. The virus has been detected in at least 24 countries. Even then, it is likely that the number of infected people has been under-reported. So far, 305 people have died, with the first victim reported being located outside of China, in the Philippines. 

It is understood that the virus originated in Wuhan, a city of 11 million people in central China. It was initially reported that the origin of the virus was the seafood and poultry market in Wuhan. However, the origin remains disputed. A study published on Lancet says that the Wuhan market might not be the origin of the virus. According to some theories (bordering on conspiracy theories), the virus might have originated from a biosafety laboratory – also based in Wuhan – housing some of the world's most deadly illnesses. The lab, opened after the outbreak of Severe Acute Respiratory Syndrome (SARS) in 2003, is used to study class four pathogens (P4), referring to the most virulent viruses which pose a high risk of “aerosol-transmitted person-to-person infections,” according to a press release. It is possible that we will not be able to establish for certain the origin of this virus, but we cannot exclude a-priori that the virus originated from lab experiments. 

Plenty of comparisons have been made with the SARS episode, which in 2002-03 infected more than 8,000 people, killing around 700 of them. Some studies have also analysed the economic costs of SARS (estimated to be around USD 13bn). According to initial statistics conducted on the first 99 patients at a hospital in Wuhan, the Coronavirus has a case-fatality rate (the percent of deaths among those infected) of 11%. Initial estimates show that the virus has an R0 of 2.2, meaning each case patient could infect more than 2 other people. If those statistic prove accurate, this virus would be more infectious than the 1918 “Spanish-Flu” pandemic virus, which had an R0 of 1.80. 

Based on current statistics, Coronavirus is definitely more infectious and deadly than SARS, and possibly also than the Spanish Flu of 1918-19, which infected more than half a billion people and killed an estimated 20-50 million (statistics were not very accurate in that case, in part because of World War I). At the same time, to most people’s surprise, the Coronavirus is less severe than the usual seasonal flu. Just to give an example, seasonal influenza epidemics cause 3 to 5 million severe cases and kill up to 650,000 people every year, according to the World Health Organization. So far in this season, there have been an estimated 19 million cases of flu, 180,000 hospitalizations and 10,000 deaths in the US alone, according to the Centers for Disease Control and Prevention.

So, what is making the Coronavirus so special, and worthy of attention, to the point that every major central banker (e.g. Fed’s Powell, BoE’s Carney and ECB’s Lagarde) had to answer a question about its impact? The point is that the panic that the outbreak has created, and the defensive reactions to it, might be causing quite a severe level of damage to the global economy (even if perhaps only temporarily, in which case the losses might be mostly recouped in the following quarters). A number of airline companies have completely interrupted all of their flights in an out from China; British Airways, which has cancelled every flight until March, being only a very notable example of this. Most importantly, the US has barred entrance to any foreigner travelling from mainland China. A number of other countries, such as Australia, have followed the US’ example. China has reacted with anger to the measures adopted by the US and other countries. China risks being isolated by the rest of the world, a position that is politically and economically difficult for Beijing to tolerate, especially as the trade and tech negotiations with the US are still ongoing, following the Phase-1 deal between the two countries.

So, more than the virus per se, it is the various countries’ reactions to the virus which pose serious downside risks to the global economy. Indeed, the global economy risks another year of stagnation, following a disappointing 2019. If that happens, central banks and fiscal authorities will likely have to do their part to support aggregate demand in the various countries directly or indirectly hit by the outbreak.  

by Brunello Rosa

27 January 2020

We have discussed several times the importance of climate change and the repercussions it may have for the economies of various countries and the global geopolitical order as a whole. Among other things, climate change causes increased desertification in areas such as Sub-Saharan Africa, the Middle East and Latin America, inducing millions of people to migrate in search for a chance to live. This in turn has helped lead to the rise of populist leaders trying to block the arrival of undesired migrants. Lately, the devastating fires in Australia show what an extraordinarily hot summer can mean for the environment, here and now, not just in some distant future. 

More recently, climate change has risen to the top of the agenda for institutions that were previously considered quite removed from this issue, such as the International Monetary Fund with the arrival of Kristalina Georgieva at its helm, the European Commission with Ursula Von der Leyen’s “Green Deal”, and central banks, with Christine Lagarde’s ECB and Mark Carney’s Bank of England leading the way. Not surprisingly, this issue were given high priority at this year’s meetings in Davos, even if it still remains unclear how and when governments and multinationals will finally decide to seriously tackle this crucial issue. Many hopes now rest on the result of the COP26 Conference in Glasgow, to be held at the end of this year. But the experience with previous COP conferences suggests that there is a need to keep expectations at a realistic level. 

In any case, it is extremely important that the level of awareness of the climate issue has finally increased, and that climate change now features very high in the agenda of policy makers.   

The European Union has decided to become a world leader in this regard, and to shape a large component of its future choices on environmental sustainability. The “Green Deal” recently launched has the potential to unlock up to EUR 1tn of public and private investments, generating hundreds of thousands of job opportunities. The Bank of England has already asked financial institutions to stress-test their resilience to climate change, considering that (as the BIS recently stated) climate change could be a cause of financial instability, if a “green swan” materialises. 

Among the various initiatives mentioned during her latest press conference, Christine Lagarde said that the ECB will make sure that its corporate bond portfolio will be designed to incentivise environmental sustainability. In Germany, the rise of the Green Party in opinion polls is constant, and in Austria the Greens joined the new conservative government formed by Sebastian Kurz.

While the US seems still to be missing in action, the key risk identified by some is the so-called “greenwashing” process, whereby anything that seems socially acceptable or politically advantageous is promoted as being a “green” initiative. Some key policy figures, such as Bundesbank President Jen Weidmann, recently made the point that central banks cannot replace good environmental policies decided by democratically elected political leaders. Others fear that good old-fashioned counter-cyclical fiscal stimulus might be masked by “green investment” to stimulate aggregate demand, thus producing good results in the short run, but no effects in the future.

As it often happens, “in medio stat virtus”. Climate change will need to be front and centre of policy makers’ agendas. But abusing the term for marketing reasons might eventually damage the cause rather than support it.    

by Brunello Rosa

20 January 2020

At the end of last year, in our paper on the six Grey Swans facing the global economy, and in our 2020 Global Economic Outlook, we said that geopolitical instability was set to increase during the US election year ahead. The strategic calculus by Trump to secure his re-election, going into 2020, was to make sure that the US economy was as strong as possible (perhaps with a bit of help from the three insurance rate cuts “independently” delivered by the Fed in 2019, which came after plenty of pressure was put on the Fed by the President), while closing some of the open geopolitical fronts, in particular the trade dispute with China.
In fact, Trump’s “art of the deal” consists of brutally shaking his counterpart before inviting it to the negotiation table and concluding a deal on more favourable terms for himself. Following this paradigm, Trump had a window of opportunity from the mid-term elections until 2020 to unsettle the system and shake his opponents, in order to then use 2020 as the period to reach compromises with his negotiating partners that he could “sell” as victories to the US public during the electoral campaign. But, as we mentioned in previous analysis, while this tactics might work in the corporate sector, where an aggressively confrontational approach could lead the counterpart to the brink of bankruptcy and therefore make it more willing to accept the harsh terms that Trump offers, in public affairs things are not that simple. States do not go bankrupt that easily, and opponents can react in unexpected ways.
So, while Trump’s preferred choice could have been that of having a strong economy and some tail risks reduced (risks such Brexit; during Trump’s intrusion in the recent electoral campaign in the UK, he basically “ordered” Nigel Farage to step back and allow Johnson’s victory), his opponents saw a clear opportunity in 2020 to “mess things up” in order to jeopardise Trump’s re-election. Domestically, the Democrats have launched an impeachment trial, which is unlikely to succeed but will still keep Trump on his toes and will expose him on a number of fronts.
The delay in sending the impeachment article to the Senate, while being borderline acceptable, has prevented Trump from having the news on the impeachment obfuscated by escalating tensions with Iran that would have otherwise occurred at the same time as one another.   
Internationally, Iran is clearly at the forefront of the historical foes that would like to see Trump go, hoping to get a Democratic president to deal with instead. This is the reason why we believe that Iran will do much more in coming months to retaliate against the killing of Qassem Suleimani, and why we believe the market is under-pricing the risk of a further escalation down the line, closer to the election date.
According to press reports, Kim Jong UN sacked its “moderate” foreign minister Ri Yong Ho, replacing him with the more hawkish Ri Son Gwon. This is seen by the intelligence community as a signal that a season of testing of ballistic missiles (launching them over key regional allies such as Japan) is about to re-start, after a period of pause. China remains the big unknown: signing the Phase-1 deal certainly gives Trump a trophy to show during the electoral campaign, and gives China the much needed break in the escalation of tariffs. At the same time, it is clear that the trade, technological and geo-strategic dispute between the two countries will continue. One possible interpretation is that China, instead of wanting to see Trump leave office, might prefer having him remain for a second term, given the damage he is doing to the US and their international relations.
All this is to say that the historical foes of the US will use the opportunity of this electoral year and Trump’s impeachment trial to take advantage of the difficulty Trump will face in providing anything other a constrained response to any moves they may make. If Trump goes from disputes to battles to open wars, he would tip the economy into recession, thus jeopardising his re-election. As such, his options this year will be relatively limited. 2020 will be most likely “a year lived dangerously” for the world.

by Brunello Rosa

13 January 2020

Financial markets became excited at the end of last week, by signals that some of the most feared tail risks hanging over the global economy could be diminishing. On a weekly basis, global stock indices rose (MSCI ACWI rose by +0.6%, to 570), driven by DM equities (S&P 500 +0.9% to 3,265; Eurostoxx 50 +0.4% to 3,790). EM indices also rose (MSCI EMs +0.9% to 1,134), and, as markets rallied, volatility fell (VIX S&P 500 fell by -1.4 points to 12.6, below its annual average of 15.0).
Regarding tensions between US and Iran, the “measured” retaliation by Iran to the killing of Quassem Soleimani, in which rockets were fired at two US military bases in Iraq without causing casualties and major damages, and the decision by the US not to respond to that attack, was interpreted by market participants as a signal of de-escalation. Some might even hope that, after a period of increased tension, the status quo ante between the two countries might return. While it is certainly a positive development that Iran’s retaliation was not followed by further US counter-attacks, we would be much more cautious before considering the events of the last few days to be merely isolated incidents that are now effectively concluded.
In our scenario analysis, we discussed how events might still develop less favourably than markets currently imply they will be and Nouriel Roubini argued that financial markets are still seriously under-pricing the possible future evolution of events. This is true for a number of reasons. First, Iran’s Supreme Leader Khamenei said that the initial attack on US bases was just the beginning of the retaliation, and that much more will occur in coming weeks. Secondly, President Trump’s invitation to the UK, France and Germany to also abandon the Joint Comprehensive Plan of Action (JCPOA) means that tensions will remain elevated for some time. Third, Iran would benefit from striking closer to the November Presidential elections, when mis-calculations could lead to Trump’s defeat. Fourth, the US has in any case launched a new series of sanctions against Iran, which could eventually lead to a further reaction by Tehran.
And finally, the unintentional downing of the Ukrainian plan by Iran on the night of the retaliation show how things can go wrong even when there is no intention to kill. In his upcoming Geopolitical Corner, John Hulsman will discuss how the Iranian story is intertwined with the electoral campaign and Trump’s impeachment process.
The second piece of good news that excited market participants was that the market the announcement by the US President that he is “ready for the Phase-1 trade deal with China to be signed on January 15th at the White House”. Trump also said he would “sign the deal with high-level representatives of China”, and that he would later “travel to Beijing to begin talks for the next phase”. The market believes that this might signal the end of the saga that rattled the global economy during the past couple of years. But again, reality might be slightly harsher than what is being hoped for. Until the deal is actually signed, anything can happen, and time is on China’s side. Why should the Chinese government provide Trump with the argument that he succeeded in containing China’s trade mis-practices ahead of the election?
Moreover, even if the trade tensions do ease, the geo-strategic rivalry between the two countries will continue, with its impact on global supply chains and technological developments. In any event, once the China issue is finally considered to be done with, Trump will then simply be ready to start a fight with Europe, over various issues such as Airbus versus Boeing, auto sector trade, digital taxes, etc. So, trade tensions worldwide could very well continue going forward.  Finally, the UK parliament has at last approved the PM’s Brexit deal, opening the gates to an orderly Brexit on January 31st, if the House of Lords does not object. At the same time, a series of cliff-edges are likely to present themselves in the next 11 months, especially now that the possibility of extending the transition period beyond 31 December 2020 has been excluded by law.
All this is to say that, while some tail risks have not materialised so far, market participants should remain aware of their presence and remember the stretched valuations that now exist in most asset classes.  

by Brunello Rosa

6 January 2020

The year has just begun, and geopolitical and political events are already accumulating. From a geopolitical perspective, the most relevant development has been the escalation of tensions in the Middle East, with the US and Iran likely to begin some form of direct and indirect military confrontation following the killing of Iranian general Quassem Soleimani in Baghdad. US President Trump reportedly ordered the attack as a retaliation for an Iran-backed militia’s attack of the US embassy in Iraq, and for the killing of a US civilian contractor on an Iraqi military base in Kirkuk. These events followed months of provocations from Iran to which the US has not responded, including a drone attack on Aramco’s refinery facilities in Saudi Arabia. Tensions between the US and Iran have been on the rise since President Trump decided to pull out of the JCPOA , the agreement between Iran and six international counterparts to limit the development of its nuclear program. That agreement was negotiated by Trump’s predecessor Barack Obama in 2015. We have discussed the run-up to these events in previous papers and scenario analyses, and shortly we will publish an updated scenario analysis, with its implications for oil prices.
From a political risk perspective, these developments have a clear bearing on the US political environment. As discussed in our recent 2020 global outlook, 2020 will be an election year in the US, and most of the macroeconomic and policy events will be driven by the developments in the US presidential race. To make things even more complicated, the US President was impeached by the House of Representatives at the end of December, and his “trial” in the Senate will start soon. As we discussed in our analysis of September 2018, regarding the risk of a global recession materialising in 2020, Trump might be tempted to “wag the dog” with military operations during his campaign for re-election, with Iran being the most likely designated target. The recent developments in the Middle East will surely help Trump obfuscate the news about his impeachment trial. He might also hope that the country will rally behind him in the event an overt conflict takes place, as it often does to presidents is similar circumstances. However, the political spectrum has thus far been divided by Trump’s decision, which reportedly was not discussed and agreed to in advance with other political leaders.       
In Europe, there are interesting political developments taking place in Spain and in Austria. In Spain, Pedro Sanchez seems on the verge of being confirmed Prime Minister, with a second vote for his “investidura” on January 7th. He managed to strike a deal not just with Podemos, but also with the independentist parties of Catalonia and the Basque Country. This solution is fraught with risks. The leader of the Esquerra Republicana de Catalunya(ERC), Oriol Junqueras, has spent the last couple of years in prison, and has been ordered to be released only recently, given his election to the European Parliament. Depending on the votes of ERC is clearly a gamble for Sanchez, considering that his government fell precisely because the Catalan parties did not support his budget. On the other hand, having both the Catalan and the Basque pro-independence parties in government could mean that a peaceful solution to Spain’s domestic conflict is likely, considering that the Catalans have always asked to be given at least the same powers and autonomy granted to the Basque Country in return for dropping their quest for independence.
In Austria, following months of negotiations, the Chancellor Sebastian Kurz managed to strike a deal to form a government with the leader of the Greens, Werner Kogler. This coalition between the conservative Austrian People's Party (ÖVP), which belongs to the European People’s Party (EPP), and the Greens, could provide the model for the next German coalition government, if the next general election (scheduled for 2021) were to result in yet another hung parliament. Such a solution could stabilise Germany’s political landscape, and provide the platform to push further European integration and stop the ongoing process of European dis-integration. European political risk was another factor discussed in our September 2018 paper on the risk of a global recession in 2020. As the recent examples from Spain and Austria show, the news from this front is mixed, and worth following in coming months.

by Brunello Rosa

30 December 2019  

In our column last week, we discussed some of the key points of our Global Economic Outlook and Strategic Asset Allocation for 2020. This week we want to focus on what we can expect from a policy perspective in the year ahead, and on policy’s implications for markets.
A number of key equity indices in the US have reached their all-time highs during the past few days. The NASDAQ, for example, touched the 9,000 mark for the first time ever on Friday 27th December. The question is whether this rally in risky asset prices is being driven by fundamentals, or whether it is being driven rather by policy intervention (or the anticipation policy intervention), in particular the large liquidity injections made by both the Fed (with the re-increase in the Fed’s balance sheet to stabilise the repo market, which some have labelled QE-4) and the ECB (which has recently re-started its own QE program).
In our Outlook we discussed how, from the monetary policy side of the equation, after the three “insurance cuts” implemented by the Fed in 2019, we now expect the US central bank to remain on hold during the 2020 electoral year, remaining open to further easing only if the economy materially worsens. We also discussed how the ECB is now undertaking open-ended QE and has an easing bias on policy rates (but its strategic review might induce a less accommodative stance). The BOJ will remain extremely accommodative; it might even add a further level of modest accommodation to accompany Japan’s fiscal stimulus. The BoE will react to Brexit developments, but is mulling over the possibility of rate cuts. The PBOC is likely to continue to provide modest monetary stimulus to cushion the Chinese economy, given trade frictions and disruptions in global supply chains.     
On the other hand, fiscal policy remains constrained but is becoming modestly expansionary. In the US, the divided Congress means that no fiscal stimulus is likely in 2020; in the Eurozone some additional fiscal flexibility is underway, especially to accompany its “green deal” and “energy transition” plans that may be attempted. Japan has approved a large fiscal stimulus (as a headline figure), which could be the basis for an effective initial version of “helicopter money”. China will keep providing some additional fiscal stimulus, despite its high fiscal deficits.
Given these considerations, we believe that in 2020 there will likely be a moderately ‘risk-on’ environment, given the improving chances that growth will stabilize, inflation will remain under control, and monetary and fiscal policies will be supportive, as well as the fact that some significant tail risks have diminished recently. Additionally, the anticipation by market participants that “helicopter drop” policies could eventually be introduced when the next economic recession and severe market downturns occur (a situation that we have labelled a “helicopter put”) is keeping the markets happy for the time being, and even frothy in some instances.
At the same time, we warned how geopolitical and domestic political tensions, a possible re-intensification of trade wars, the continued disruption of global supply chains, tighter financial conditions, and market valuations disconnected from underlying macro fundamentals could cause sudden market corrections that investors should be wary of during the new year ahead.

By Brunello Rosa

23 December 2019  

Last week we published our Global Outlook and Strategic Asset Allocation for 2020. We discussed our growth, inflation, policy and market forecasts for the year that is about to begin, with baseline, downside and upside scenarios. We also discussed the main macroeconomic and market themes for 2020, with their implications for market and asset allocation.
In our global overview, we mentioned how 2019 was characterised by a synchronized global economic slowdown, but with a strong rally of risky assets, such as US and global equities. The slowdown was driven by a number of geopolitical risks, such as the escalating trade and tech war between the US and China, the risks of a hard Brexit, and increasing tensions in the Middle East. These helped lead to a recession in the manufacturing sector. Now, in our baseline scenario for 2020, we expect this slowdown and stagnation of the major developed market economies to continue. We are less convinced however by the global reflation story that other research houses, especially in the sell-side of the financial industry, are pushing these days.
Equally, we consider a global recession in 2020 to be a risk scenario, at this stage. In a series of articles published in the second half of 2018 we discussed the possibility of a severe market correction and a global recession occurring as early as in 2020, and we outlined the ten factors that could lead to such an outcome. At the same time, in a more in-depth analysis, we discussed the ten reasons why a milder scenario could materialise, in spite of those threats.
Chief among these ten reasons were an accommodation in the global monetary policy stance and a containment of the geopolitical risks, both of which have occurred since then, thereby reducing the probability of a global recession in 2020. Nevertheless, geopolitical and domestic political tensions, an increase in trade wars, disruption of global supply chains, tighter financial conditions, and market valuations disconnected from underlying macro fundamentals could still cause sudden market corrections: investors need to remain aware of these risks in the year ahead.
Given this background, the current environment calls for a moderately ‘risk-on’ position in 2020. There is a high probability that trade and political tensions will de-escalate. A more balanced policy mix is expected to emerge. Variants of “helicopter money” policies could eventually be introduced when the next economic recession and severe market downturn finally occur. From an asset allocation perspective, over the next few years, the investment environment remains challenging, because central bank liquidity and geopolitical risks are likely to matter more than fundamentals and market volatility is likely to rise, hampering portfolio performances and increasing the likelihood of corrections and, eventually, bear markets. As a result, “expected returns” are likely to be lower than in the pre-2008 crisis period. Investors, over a multi-year horizon, will therefore have to accept lower expected returns in exchange for lower volatility, and while riding the liquidity wave remain aware of the risks mentioned above.    

By Brunello Rosa

16 December 2019  

As we discussed in our in-depth analysis, the UK general election resulted in a historic victory for the Tory Party, which will now gain the largest parliamentary majority of any British government since 1987, under PM Thatcher. It was also the worst electoral defeat for the Labour Party since 1935. The Conservatives gained 48 seats (for a total of 365) compared to their performance in the 2017 general election.  The Scottish National Party gained 13 seats (for a total of 48), while Labour lost 59 seats (bringing it down to 202) and the Liberal Democrats lost 1 (it now has 11). Still, the Conservative victory was unquestionable only in England, where Labour now remains strong only in urban areas. Regional parties won their respective nations: Plaid Cymru in Wales, Sinn Fein and DUP in Northern Ireland, and especially the SNP in Scotland.
As of now, we believe that the main political consequences of the vote will be the following: (1) Boris Johnson remains prime minister and, as discussed below, will carry on with his Brexit plan; (2) Jeremy Corbyn, who already said that he will not lead the Labour party at the next general election, will likely resign from his position as party leader in the next few weeks; Labour will now face a harsh leadership contest between the so-called “True Corbynistas”, such as Rebecca Long-Bailey, currently the shadow business secretary, and moderate left-wing figures such as Keir Starmer, the shadow Brexit secretary. If the party does not want to disappear, it will likely shift back to the centre in coming years, following the disastrous results of Corbyn’s attempt to bring Marxism back into the UK political system; (3) Jo Swinson, the Lib-Dem leader who lost her seat in favour of a SNP MP, will also likely resign her position as party leader in the next few days. She carries the responsibility for having forced Labour to accept this snap election that has led to the largest Tory victory in recent history; (4) Nicola Sturgeon, whose SNP party has won 48 out of the 59 seats in Scotland, will press further for a second referendum on Scottish independence.
At this point, Brexit will happen for certain, most likely by January 31st, as is currently planned. This does not automatically mean the end of the Brexit uncertainty. Boris Johnson has promised to conclude a trade deal with the EU by 31 December 2020, a virtually impossible task unless by reaching a deal he means merely an agreement in principle, or only a sort of UK version of the “Phase-1 deal” from the US-China trade dispute. A renewed phase of uncertainty might therefore occur towards the end of the year, when a no-deal Brexit could once again become a possibility if the transition period is not postponed to 2022. The decision must be made by 30 June 2020, and given the ample majority that will now exist in parliament, and the government’s strong negotiating position deriving from the large popular mandate the election has given it, it is unlikely as of now that Johnson will request such an extension in the summer.
Most importantly, if Johnson’s deal is finally approved by parliament, Northern Ireland will become a very special zone. It will be part of both the UK and the EU customs unions, a privileged position that Scotland especially would aspire to have. As in the case of Spain, where the Catalans ask to have the same privileges of the Basque Country in return for giving up their quest for independence, Scotland will probably ask to obtain the same status as Northern Ireland in return for giving up its intention to ask for a second independence referendum.
To conclude, while this election has removed some of the Brexit-related uncertainty and all of the Corbyn-related fears, the road ahead for the UK remains bumpy and winding. For this reason, it is likely that fiscal policy will be more growth-friendly, and monetary policy will remain supportive. As such, the election-induced GBP rally might prove to be more short-lived than is currently thought.     

By Brunello Rosa

9 December 2019  

After a few weeks during which G10 central banks did not make any major decisions, in December nearly all ten of them will hold their policy meetings. Last week, the boards of both the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) met to decide the course of their respective monetary policies for the coming months. The BoC left its policy rate unchanged at 1.75%, as had been expected it would. It is the highest such rate among the G10 countries. The BoC’s position is, broadly speaking, “neutral”: the Bank’s statement did not express any particular bias towards either raising rates further or cutting them in the near term. The Bank can enjoy Canada’s inflation being on target and growth being not too distant from its potential level, and so can afford to wait longer before deciding what to do. Clearly, the most relevant factor will be the outcome of the trade negotiations between China and US, given that the Canadian economy is highly dependent on both those economies. It will also depend on oil prices, which tend to move in tandem with global growth. If the US and China manage to agree to at least the Phase-1 deal (as we expect they will), the Bank of Canada will be able to stay on hold for longer, hoping that a pickup in global growth does not  eventually lead to cutting its policy rates.
On the other side of the world, in Australia, the RBA also kept its rate unchanged at 0.75%, but in this case after having already cut rates three times this year, for a cumulative amount of 75bps. Like Canada, the Australian economy is highly dependent on the US, China, global growth and the commodity cycle, which is why the RBA has already also started to explore which unconventional measures it might use if and when its policy rate reaches the effective lower bound of 0.25%. Governor Lowe said that the RBA would be ready to start a QE program of purchases of sovereign bonds in case extra easing is needed, also thanks the additional supply of bonds deriving from the expected fiscal stimulus. So, while the BoC’s position was effectively neutral, in the case of the RBA we can see there exists a clear easing bias.
In the week ahead, the two largest central banks will meet: the Fed and the ECB. As we will discuss in our forthcoming preview, the Fed, which has officially declared itself to be “on pause”, will have to calibrate this message in order not to be pushed around further by President Trump during the coming election year, Trump wanting rates to be cut even more. The ECB’s job is equally challenging. Its policy stance is currently on some sort of auto pilot: open-ended QE, full reinvestment of proceeds, easing bias on rates, and reserve tiering for core-EZ banks and TLTROIII for periphery-EZ banks. But the arrival of a new president at the helm of the institution – namely, Lagarde replacing Draghi – marks the beginning of a transition period that could last a few months. The announced review of policy strategy is a double-edged sword. On the one hand, Lagarde my end up taking ownership of the current policy stance; on the other hand, the review could be the beginning of a reversal of some policy tools. Also this week, the central bank of Switzerland (the SNB) will meet, but as we will discuss in our forthcoming preview we do not expect major changes in its policy stance to be made.
The following week, on Thursday, there will be a number of important central bank meetings: the BoJ, the BoE, Norway’s Norges Bank and Sweden’s Riksbank. The BoE is unlikely to do anything just a week after the general election: it remains to be seen whether the dissenters within the Monetary Policy Commitee will keep or change their vote to “no change”. Norges Bank has already reached “pause” levels, and we do not expect them to do anything at this meeting. More interesting will be to see what the BoJ will do, since the government has finally launched a supplementary budget  (which includes a larger-than-expected USD 121bn stimulus package), as the Bank had been clearly demanding it do. Finally, and perhaps surprisingly, the Riksbank is likely to increase its policy rate, as we mentioned in our latest review. It may take its repo rate from -0.25 percent to zero, before entering what will likely be a long period of pause.    

By Brunello Rosa

2 December 2019  

Two important events shook Germany’s political landscape this past weekend. On the left, the Social-Democratic Party (SPD) chose the radical couple Norbert Walter-Borjans and Saskia Esken as new co-leaders of the party, instead of finance minister Olaf Scholz and Klara Geywitz who they defeated in the party’s leadership race. Scholz and Geywitz were perceived as champions of the status quo, which basically means the SPD remaining in the grand coalition with Angela Merkel’s CDU. Walter-Borjans and Esken however have proposed a more radical platform, which requires the re-negotiation of the “coalition contract” and foresees the rupture of the grand coalition as a possibility.
At the opposite side of the political spectrum, Alternative für Deutschland (AfD) chose a relatively moderate (by AfD standards) ticket to lead the party, after the unifying figure of Alexander Gauland decided not to run again for the party’s leadership in order to allow a generational changeover to occur (Gauland is 78 years old). The party, which already holds 94 seats in the German Bundestag (out of 709) and is the third largest party after the CDU and the SPD, chose as co-leaders Tino Chrupalla and Joerg Meuthen. Chrupalla is a legislator from Saxony, who will represent the former communist states of the East where AfD surged in three elections this year. Meuthen is a professor of economics in the industrial south-western state of Baden-Wuerttemberg. Contrary to the SPD’s decision to choose a leadership ticket that may distance itself from Merkel’s CDU, the unusually moderate choice by the AfD was specifically made to allow the AfD to become a potential ally of the CDU, at least at the local and state government levels.
The selection of these new leaders of the SPD and the AfD occured just over a week after the CDU confirmed Annegret Kramp-Karrenbauer (AKK) as leader of the CDU. Where do these events leave Germany, and what implications might they have for the broader European integration process?
From a domestic standpoint, Germany’s political instability is now clearly on the rise. If the SPD does pull the plug on the government, Merkel might either lead a minority government, or try to strike another coalition deal, or call a snap election. In such an election, the Greens would likely emerge as the first party of the left, which would open up three options (assuming that no party has enough seats to govern alone): 1) A CDU-Green grand coalition, if the CDU emerges as the first party in the election. (But, such an outcome might not be the case if AKK remains as CDU party leader, as she might not be able to guarantee that the CDU will end up as the first party in the election); 2) A new attempt of the Jamaica coalition (CDU-Greens-Liberals); and 3) an alt-left coalition between the Greens, the SPD and the Linke. That is, assuming the three parties together have enough seats, and assuming the Linke compromises on key policies such as Germany’s participation in NATO. In any case, it is clear that the myth of Germany’s political stability is now a relic of the past.
For the broader European integration process (now that Ursula Von Der Leyen has been confirmed as president of the EU Commission) these political events could be either positive or negative. They might be positive if the ongoing political tsunami in Germany were to bring to power the Greens in a relatively stable coalition (a “grand” coalition with the CDU, a leftist coalition with the SPD and Linke, or the “Jamaican” coalition). The Greens are undoubtedly pro-Europeans even if in favour of fiscal discipline, and are advocates of the “green” new deal that in Europe is likely to become the proxy for much-needed fiscal stimulus. German politics might be negative for European integration, on the other hand,  if the country’s political instability were to lead to a stalemate within its own decision-making process: Germany remains the largest, richest and most influential country in Europe, without which no decisions are made. The events of the next few weeks will determine which of these outcomes will ultimately prevail.    

By Brunello Rosa

25 November 2019  

For better or worse, 2020 will be characterised by the US Presidential race, which will not end until November 3, the day the election will be held. President Trump has made all possible efforts to make this election a referendum on himself and his style of being president. He has polarised the US political landscape like very few presidents before him ever have, with his abrasive conduct of government affairs, partly inherited from his business days when he was using his “art of the deal” to get things done. 

In politics, and especially in foreign policy, his approach of hitting counterparts as hard as possible before inviting them to the negotiating table has not always worked. Sovereign institutions are not businesses that can be brought to the brink of bankruptcy to soften their negotiating positions. Hence the failed negotiations with the North Korean dictator over that country’s nuclear program, the standstill with the Iranians over the nuclear deal and Middle East policy in general, and the protracted negotiations with China over trade and tech arrangements, which have so far produced at most a “Phase-1” informal agreement. 

Regarding the US domestic agenda, President Trump is trying to show that he continues to side with the deprived working class in urban areas and with under-privileged populations in rural areas. For some reason, the president’s narrative is still popular in the country, even though the reality is that some of these domestic issues are actually bi-partisan. For example, every president, Republican or Democratic, would have had to start taking on China and its trade surplus vis-a-vis the US, as well as its unfair tech and IP practices. Perhaps Trump’s unorthodox style and abrasive approach make his positions less acceptable to many who would otherwise support such positions if it were a more conventional politician who was championing them.    

Indeed, to some extent Trump may have actually surprised to the upside in his policy stances, by being less trigger happy than what could have been expected from him, especially after surrounding himself with very hawkish advisers and officials such as John Bolton and Mike Pompeo.  For example, he did not respond to the provocations of North Korea and Iran in the last couple of years, and has not directly intervened in Venezuela as some of his predecessors would perhaps have done. Trump might turn out to be just another isolationist Republican president. 

In any event, the electoral campaign is beginning to heat up. The impeachment hearings are turning awry for Trump, with the testimony of people close to the president such as Gordon Sondland, the US ambassador to the EU, and Fiona Hill, a senior National Security Council official. For now, the baseline scenario will continue to be that President Trump is likely to be impeached in the House, but not convicted in the Senate, where 20 Republican votes are needed to reach the necessary two-third majority of 67 votes. 

However, the more embarrassing the hearings become for the Trump administration, the more Republican senators might decide to turn their back on the president if and when an impeachment vote is held. If the president’s position weakens as a result, he might induce some of his external enemies, like China, Iran, or North Korea, to scale up the level of provocations during the electoral year, to see whether a more tense international environment make Trump lose enough votes in the key swing states he will need to win a second term. 

What about Trump’s Democratic opponents? As we discussed in our recent analysis, the frontrunner Joe Biden has been damaged by “Kyiv-gate” more than Trump has so far, so much so that Pete Buttigieg now seems to be leading the race in Iowa and New Hampshire, which are the first states that will hold primary elections. To counterbalance the rise of Elizabeth Warren, a left-wing candidate who has spooked the market with her radical reforms made up of universal healthcare coverage and wealth taxes, Michael Bloomberg, the former mayor of New York, has now launched his own campaign to win the Democratic nomination. His presence will make the race in the Democratic camp more uncertain. If he wins the nomination, we would then see two New York billionaires running against each other to become, or in Trump’s case, to remain, President of the United States in November.     

By Brunello Rosa

18 November 2019  

A number of economists and commentators are discussing the question of what the most effective fiscal and monetary policy response to the next global financial and economic downturn will be. There seems to be a consensus forming that, with global interest rates as low as they currently are (in some regions, nominal policy rates are negative), some form of fiscal and monetary coordination will be needed when the next crisis hits. Most recently, Gavyn Davies has discussed the role of automatic stabilisers, like indirect taxes and forms of unemployment insurance, in such a context, highlighting how this form of automatic support to aggregate demand is weaker in the US than in Europe, for example. 

In our recent analysis, we discussed in depth what form this monetary/fiscal cooperation could take, citing the examples of “helicopter drops of money,” “People’s QE”, “Modern Monetary Theory” and other more mainstream forms of fiscal-monetary coordination such as that which was recently proposed by former Fed’s Vice Chairman Stanley Fisher and former SNB chief Philipp Hildebrand, and describing their pros and cons. Our impression is that this idea of monetising fiscal deficits, far from being new (let alone “modern”), is actually becoming mainstream, and will likely provide the theoretical foundation for the policy response to the next economic and financial downturn, especially if the next downturn is severe.

This discussion is already having a very positive impact on financial markets. As we discussed in our column two weeks ago, markets are already celebrating the reduction of tail risks (US-China trade tensions, Brexit, the IMF-Argentina confrontation, etc.) and the additional monetary stimulus (such as that which was delivered by the Fed at the end of October) that are accompanying the stabilisation of key macroeconomic indicators such as manufacturing PMIs (which seem to be bottoming out, while remaining in contractionary territory).   We concluded that column by saying that markets are already pricing in some form of fiscal and monetary backstop that they expect to be provided when the next crisis hits. This is like counting on a massive “fiscal and monetary put” available at the global level. 

In this imaginary bridge between where we are now (a synchronised global slowdown) and where we are likely to be in a few quarters from now (a recovery phase driven by a coordinated fiscal and monetary policy response at the global level) the question is what will take place in between. For certain, monetary authorities will be prudent, and policy rates will be kept lower than what they would have been if this recovery had taken place pre-2008 crisis. Hence, policy rates are likely to be kept low, if not lower than they are now, for longer. 

This might not be enough to prevent a sudden reversal in the imbalances that are building up and will continue to build up, in part even as a result of this very prudent monetary policy. For example, in H1-2019, global debt rose above USD 250tn, with China and the US accounting for more than 60% of new borrowing (with worrisome levels in the corporate debt sector). As such, a “non-linear” event in the middle of the bridge between the current global slowdown and future global recovery seems hard to avoid at some point. A coordinated fiscal-monetary action will then occur, providing the necessary policy response.  

By Brunello Rosa

11 November 2019  

Spain’s general election has resulted in yet another hung parliament. The final results suggest that the Socialist Party (PSOE) of the incumbent Prime Minister Pedro Sanchez has obtained a plurality of votes (around 28%), but very far from a level that would allow Sanchez to obtain a majority of seats in the Congreso De Los Diputados, the country’s main legislature at the national level. The Socialist Party will have 120 seats, out of the possible 350. Pablo Iglesias’ Unidas Podemos has collapsed, meanwhile, receiving only around 13% of votes and 35 seats. Podemos probably paid a political price for the intransigent position they had taken during the negotiations that followed the April 2019 election, which had failed to lead to the formation of a new Sanchez government. The new party born to the left of PSOE, Mas Pais, obtained 2.4% of votes (most likely from both PSOE and Podemos) and 3 seats. 

On the right of the political spectrum, the Ciudadanos party led by Albert Rivera has also collapsed in these elections, from 16% of votes and 57 seats to 6.8%of votes and 10 seats. 

Critics are saying the party has run out of “marketable” political material. It is also true that Ciudadanos’ intransigent position regarding the Catalan separatists had already paid off, with the incarceration and severe sentences of the leaders of the “rebellion”, and that its outlook is in any case well represented by the even tougher positions taken by the rising Vox party. 

Vox, led by the controversial figure Santiago Abascal, has staged the best performance of all, rising from 24 seats in the previous legislature to 52 in the new one. It received 15.1% of all votes, which despite being only around half as many as the Socialists, is nevertheless a 30% increase from the votes Vox had received in April 2019. This is yet another confirmation that nationalist-populist parties are still strong in Europe, and still represent a serious threat to the European integration process. The People’s Party (PP), led by Pablo Casado, has also increased its votes (+4.1% to 20.8%) and seats (+22 to 88). Other parties, including regional ones from Catalonia and the Basque Country, gained a combined 42 seats.  

Where will Spain go from here? As we discussed in our in-depth election preview, Spain’s political stability is long gone, as the fact that this was its fourth general election in four years clearly shows. At the same time, Spain’s two traditional parties, PSOE and PP, plus the newer parties from the left (Podemos) and the right (Ciudadanos), cannot afford not to be able to form a government after this election. If they do not manage to form a government, there is a risk that the protest vote will rally around the newest party on the political scene, Vox, which has the potential to wipe out both Podemos and Ciudadanos and drain further votes from PP and PSOE. As such, we believe that these parties will do all it takes to form a government this time. 

Given the number of seats available, Sanchez is very likely to be given the first chance to form a government. He will probably go back to Podemos and try to form a majority with them and some of the other left-wing parties (such as Mas Pais) and regional parties, or if not a majority than at least a parliamentary bloc large enough to form a minority coalition government. If this attempt were to fail, the three right-wing parties (PP, Ciudadanos and Vox) might try to form a coalition – the same grouping that took over the Andalusian regional parliament in December 2018, following decades of unrivalled Socialist rule in that region. 

If neither of these two relatively “natural” solutions work out, Spain might instead try to form, for the first time in its recent history, a German-style “grand coalition” between PSOE and PP, which together would command a comfortable majority. A weaker form of this grand coalition could be a PSOE-only minority government, which can be formed thanks to the abstention of the PP (which, in this way, would “return the favour” that the PSOE did to Rajoy in 2016). But the risks deriving from this type of solution are well-known in those countries that have experienced them (chiefly, in Germany, Austria and, more recently, Italy). Grand coalitions tend to reinforce support for extremist parties, especially those on the right side of the political spectrum (AfD, FPÖ, and Lega, respectively). With Vox already on the rise, a PSOE-PP coalition is therefore a solution we believe will be attempted only at the very end, if all else has failed.

By Brunello Rosa

4 November 2019  

In our column two weeks ago, we discussed how several key tail risks that were weighing on the global economy were in the process of being reduced, and how that could prove beneficial for risky asset prices. In particular, we noted the following: how the risk of hard Brexit was diminished since Boris Johnson had obtained a new deal from the EU and managed to obtain early elections; US-China trade tensions were lower after the Phase 1 agreement was reached between President Trump and Chinese Vice Premier Liu He; the risk of an open confrontation in the Middle East involving Iran, Saudi Arabia and the US currently seems to be relatively low; the risk of a collision course between Argentina and the IMF seems contained for now, even after the victory of Alberto Fernández in recent presidential elections.

Together with these reduced tail risks, there have been also some positive surprises from the real economy, in particular in the US. Last week, the advanced reading of Q3 US GDP showed a smaller deceleration of growth than initially feared (from 2.0% to 1.9% SAAR, versus 1.6% expected), and October’s Non-Farm Payroll increase was 128,000 (versus 89,000 expected), with September’s data upwardly revised from 136,000 to 180,000. Other positive figures from the US labour market were a small increase in average hourly earnings (3.0%) and an increase in the labour force participation rate (to 63.3%, versus an expected decrease to 63.1%, from September’s 63.2%), which partially justify the uptick seen in the unemployment rate, from 3.5% to 3.6%. 

Finally, the Federal Reserve provided an additional kick, with its third back-to-back insurance cut last week, which brought the Fed funds target range to 1.50%-1.75%. The impact on financial markets was powerful, with global equity indices rising substantially: MSCI ACWI was up +1.3% on a weekly basis, driven by strong performance in both DMs (MSCI World, +1.3% w-o-w and S&P 500, +1.5% w-o-w, to 3,067, its all-time high) and EMs (MSCI EMs, +1.3% w-o-w).  

Some analysts even wondered whether the easing the Fed has provided since July 2019 (and the interrupting of its tightening cycle since last December) were actually necessary. In our view the answer is yes, the easing was necessary. The manufacturing recession is still ongoing; on Monday the manufacturing ISM rose less than expected to 48.3, still well below the 50 mark, which separates expansion from contraction. Consumer and business sentiment remains fragile, and the risk of an increase in consumer tariffs on December 15th remains present, albeit diminished. So, most likely a mid-cycle policy adjustment was warranted, especially considering a reduced neutral real rate (r*), as was mentioned by Chair Powell during his latest press conference.

Where do we go from here? The Fed has already clearly signalled a period of long pause, which would require dramatic changes in economic and financial conditions in either direction to be interrupted. Indeed, it would likely require either a sharp and persistent increase in inflation above the 2% target, or a consistent deterioration in economic growth, for this pause to be ended. Other central banks are taking a cue from the Fed, meanwhile. The Bank of Canada left its policy rates unchanged (even if with a clear easing bias) in October. The Bank of Japan bought more time before providing more stimulus. The Riksbank even signalled its intention to increase its policy rate (and “normalise” it to 0%) before entering a long pause. This week, the Reserve Bank of Australia is expected to pause its easing cycle (after three 25-bps cuts this year). The Bank of England will remain on hold ahead of the December 12th general election. 

As a result, some of the euphoria currently observed in financial markets might be tamed in coming weeks. But don’t worry: in due course, when the situation will have deteriorated enough, central banks will be ready to deploy “helicopter money” to support the global economy and financial markets.   

By Brunello Rosa

28 October 2019  

Argentina and Uruguay went to the polls yesterday to elect new presidents, at the same time as a wave of protests has been hitting Latina America. Argentina elected a Peronist president again: Alberto Fernández, who will have as his Vice President Cristina Fernández de Kirchner, the former president of Argentina from 2007 to 2015. This is coming after the failure of the Macri presidency to implement liberal reforms and bring Argentina back to international capital markets. When Mauricio Macri was elected president of Argentina in 2015, his campaign was based on the motto “Argentina is open for business.” Macri’s plan was to definitively end the preceding Peronist era, in which Argentina had experienced a very volatile economic performance, rising public subsidies and inflation, and endless disputes with international investors over bonds restructured after the 2001 default.
Things seemed to be going in the right direction until early 2018, when a drought hit the country and a series of policy mistakes led markets to massively short the peso. The subsequent collapse in economic activity, the rise in inflation (55% y/y, the highest in the world after Venezuela and Zimbabwe) and a shortage of reserves led Macri to go back, cap in hand, to the IMF to ask for a bailout. The IMF granted the bailout: USD 57bn, the largest loan in the IMF’s history. This gave Fernández a formidable argument against Macri in the recent election campaign. He was able to say that the 2018 bailout was brought about by the Macri government’s adoption of the IMF-inspired liberal reforms (just like how the 2001 default was caused in part by the collapse of the “currency board” inspired by the “Chicago school”). In other words, instead of opening the country for business, liberal reforms have led it to default. The obvious conclusion (Fernández’ argument goes) is that only Peronism can work in Argentina. This argument has clearly been accepted by Argentina’s population in 2019.
At this point, the key question is what type of policies Fernández will adopt once he is elected. As we discussed in our recent in-depth analysis, Fernández is likely to opt for a middle ground between an orthodox approach and a fully populist approach. He knows Argentina needs a constructive dialogue with the IMF, as it will likely need more financial support in coming months. The IMF too knows that a constructive dialogue with Argentina is necessary: having already disbursed USD 44bn, it will need to keep the relationship healthy and intact if it wants to have a chance of seeing this debt repaid at some point.   
Argentina might be a special case, but other LatAm countries are undergoing a difficult transition period as well. As mentioned above, Uruguay also went to the polls yesterday, to elect a successor to President Tabaré Vásquez, who could not run again due to constitutional term limits. Polls were held in the middle of a surge in crime (specifically, of murders and burglaries), which some attribute to the liberalisation of cannabis adopted by the government. Bolivia just had its presidential election, meanwhile, the result of which was that Evo Morales managed to win a second term, which led to disputes about transparency and protests against claims of alleged fraud in the election results.
Besides the basket case of Venezuela and the yet-to-be-confirmed hopes in AMLO’s Mexico, the two most worrying cases in the region of late are Ecuador and Chile. In Ecuador, protests recently erupted as Lenín Moreno, who in 2017 succeeded Rafael Correa (from the same party), in practice made a U-turn on a number of the government’s previous policies, for example by handing back a US military base that had previously been confisca­ted by Correa, and by steering the country back toward austerity and neoliberal reforms. In Chile, President Sebastian Piñera has reshuffled his entire cabinet as a result of the widespread protests that were triggered by an increase in transportation costs and the more general rise in inequality.
All this has been occurring while, in Colombia, President Iván Duque Márquez is trying to secure a final peace arrangement with the FARC, and in Brazil President Bolsonaro is passing a controversial pension reform in parliament.  

By Brunello Rosa

21 October 2019  

The IMF/World Bank meetings that just concluded in Washington DC were an occasion for policy makers, market participants, academics and other observers to take stock of the current worldwide macroeconomic, financial and geo-political environment. In its latest edition of the World Economic Outlook, the IMF warned about the synchronised global slowdown now taking place - the opposite of the global synchronised expansion that occurred in 2017-18. The outlook for the global economy has been downgraded, with the forecasts for growth in a number of key economies being revised downwards. The downgrade could have been even larger if it was not for the large positive contribution to growth from countries such as Brazil, Iran and Turkey (whose economy have stabilised after a severe recession). All this is happening at a time when policy makers’ fears of a global recession are increasing.
In this precarious global economic environment, some of the tail risks that could have tipped this global slowdown into a global recession seems have been diminishing in the last few weeks. Just to focus on the four economic collision courses recently identified by Nouriel Roubini, we can say that the risk that such collisions actually materialise is, for the time being, slightly lower than had been the case until recently. In the US-China trade dispute, there now seems to be at least a “Phase 1” agreement, which should be finalised by the APEC meeting in November. If such finalisation does indeed occur, then perhaps the feared increase in tariffs on consumer goods that would have come into effect in mid-December is not going to occur. That would certainly help provide a respite to the global economy.
Regarding Brexit, it seems that the new deal signed between the UK and the EUlast week should eventually lead - even if only at the end of a tortuous path - to an outcome that does not include a hard Brexit. In the Middle East, the tensions between the US, Saudi Arabia and Iran persist, but seem unlikely to escalate further into an open military confrontation. As the decision to pull out of Syriashows, the US seems inclined to disengage further from the region, rather than engaging in a new conflict that could mean putting US boots on Middle Eastern ground yet again. Thus for now the US seems inclined to resist the temptation to respond to Iranian provocations.   
Finally, as far as Argentina is concerned, it seems that Alberto Fernandez, the Peronist candidate supported by Cristina Kirchner, is aware of the need to constructively engage in a conversation with the IMF, rather than put up a fight which could lead to a nasty outcome for all sides involved. If all four of these tail risks are reduced – US-China negotiations, Brexit, the Middle East, and Argentina – the danger coming from some of these potential triggers of a global recession would be lessened as a result.
Clearly, if these four fronts become less dangerous, new ones might open up. For example, by November 17th the US administration will have to decide whether or not to start imposing tariffs on the European auto sector. Such tariffs could have a large economic impact on the European economy. For the time being, it seems that the US administration will postpone the decision for a bit longer, as the Chinese front has not closed yet. Germany’s grand coalition could collapse as a result of new local elections or the change of leadership at the helm of the SPD. Older risks could resurface as well, for example if the Italian government were to collapse sooner than expected as a result of the continued tensions within its majority.
Reducing the likelihood of some of these triggers is as important as deploying a policy response to them. In this respect, the Fed and the ECB (and a number of smaller central banks, such as RBA and RBNZ) have started to do their part. More needs to be done, especially in terms of fiscal policy, but at least policy makers are alerted about the need to be vigilant and responsive, even if they are incapable of being proactive. At the same time, the IMF will begin a formal review of the effects of the unconventional monetary measures adopted by several central banks around the world, which hopefully will not lead to a sudden abandonment of such measures. In Europe, the ECB will carry out its own review of strategy, tools and communication, with the arrival of Christine Lagarde at the helm.
Given this background, risk in financial markets seems to be on rather than off. Risky asset prices are still close to their highs, long-term yields are low and credit spreads are tight. The IMF’s Global Financial Stability Report, also published last week, warns about the risks posed by a mounting level of corporate debt of dubious quality. The Financial Stability Board says that it is alerted to this, but is not yet alarmed by it; early in 2020 it will publish a report where is likely to acknowledge this. At the same time, market sentiment remains vulnerable to any swings in economic, geopolitical and policy developments. 

By Brunello Rosa

14 October 2019  

During a week in which the Nobel Peace Prize was granted to Ethiopia’s Prime Minister Abiy Ahmed Ali, for his “efforts to achieve peace and international cooperation, and in particular for his decisive initiative to resolve the border conflict with neighbouring Eritrea," still another new conflict is starting in the Middle East. After Donald Trump’s decision to withdraw US troops from the north-eastern corner of Syria, Turkey decided to occupy a strip of 20km inside that region to create a buffer zone. The occupation has two declared goals: to make it easier for the Turkish army to defend Turkey’s borders, and to relocate to Syria a portion of the 3.6m Syrian refugees currently living in Turkey.
As part of this offensive (somehow ironically named “Operation Peace Spring”) Turkish troops have launched a series of airstrikes and artillery bombardment against the Syrian Democratic Forces (SDF), forces which have helped the US-led coalition in Syria to fight ISIS, but which Erdoğan considers effectively a terrorist organisation. This is because the SDF are led by the Kurdish People's Protection Units (YPG), which Turkey considers a terrorist group. So, this “Operation Peace Spring” will be directed mainly against the Kurdish ethnic groups, which Erdoğan has long considered a threat to Turkey’s national unity and security.
The US position on this issue is contradictory at best. The US Department of Defense was reportedly against the abandonment of Northern Syria by US troops, and even Lindsey Graham, an ally of President Trump, said he would seek to introduce a bi-partisan resolution in the US Senate to reverse the decision and punish Turkey, if Turkey decides to attack the SDF. Trump himself, after giving green light to the Turkish invasion of Northern Syria, said that he would “obliterate” the Turkish economy if its actions were to be “off-limits”, or “inhumane.” In a spectacular U-turn, US Secretary of State Mike Pompeo said that the US did not give green light to the Turkish offensive in Syria, even as the official press statement following the phone call between Trump and Erdoğan states that “Turkey will soon be moving forward with its long-planned operation into Northern Syria”.
Europe’s reaction has, for a change, been to unanimously condemn this brutal military operation. But it has also, as usual, been ineffective. This is because the EU is in no position to tell Erdoğan what to do, after making a treaty with him on 18 March 2016, the result of which has been that the EU has paid Turkey EUR 6bn for two years in return for keeping the Syrian refugees on Turkish territory. Ahead of the renegotiation of this atrocious deal in 2020, Erdoğan is now threatening to open the gates of its refugee camps and flood Europe with migrants, as happened in 2015. Then, Angela Merkel decided to accept 1.1 million refugees in Germany (and, in so doing, marked the beginning of her own political decline) and Italy and Greece also dealt with hundreds of thousands of migrants coming from (or through) the Middle East by land and sea, while Hungary and other countries closed their borders.
If Erdoğan were to do what he is threatening to do – a scenario we do not expect to happen – the EU would not now be able to cope with such a migration crisis the same way it did in 2015. Germany would be unwilling and unable to accept more migrants, since the CDU has been severely punished for that humanitarian decision by Merkel in 2015. Italy, after the “security decrees” by Salvini (which are still active), has closed its ports to the ships rescuing migrants. Greece is now governed by a centre-right government much tougher on migration than Syriza’s far-left positions were. The Viségrad group (Poland, Hungary, Czechia and Slovakia) remains resolutely against any re-distribution of migrants within the EU (even as they continue to collect, financially, the “solidarity contributions” from larger EU countries). The EU Commission is in the middle of a difficult transition from Juncker’s presidency to Von Der Leyen’s, preventing it from making any big decisions. So, another migration crisis would most likely destabilize Europe, sending it close to collapse. A dis-integration of Europe would have large economic, financial and social consequences.
This means that Erdoğan’s threat is credible. Unfortunately, the likely conclusion to all this is that the EU will renew its deal with Turkey, and receive only a somewhat less “inhumane” war in Northern Syria than would otherwise occur.  

By Brunello Rosa

7 October 2019  

Following a number of warning signals, a European front in the global trade wars has now been opened by the World Trade Organisation (WTO). In a recent ruling on a 15-year old dispute, the WTO ruled that the US is authorised to apply tariffs worth USD 7.5 billion annually on the UK, France, Germany, and Spain (the “Airbus nations”), as well as on the wider EU, as a compensation for the subsidies that the EU has allegedly given to Airbus, providing the company with an unfair advantage against its US rival Boeing. Similarly, in a separate ruling that is expected in the months ahead, the EU is likely to be authorised to impose tariffs (likely billions of dollars worth) on EU imports of US goods, due to the subsidies that the US government has provided to Boeing. This could mark the beginning of a tit-for-tat escalation between the EU and US, which could prove damaging for both sides.
Ironically, it is the WTO, an international body devoted to the resolution of trade disputes, that is risking opening this new front in the ongoing international trade wars. As discussed in our previous analysis, US President Trump has opened a number of fronts for his country’s trade wars: he began by withdrawing the US from the TPP, then continued with a worldwide tariff increase on steel and aluminium (even imposing such tariffs on its close allies Canada, Europe and Japan, albeit with selective exemptions), then moved to the re-write of NAFTA with Canadaand Mexico, and finally finished in style with China, subjecting it to several rounds of tariff increases as well as technological disputes. When it seemed that on the Chinese front a deal could finally be reached, Trump was ready to wage war to Europe and the European car industry. The procrastination of the negotiations with the Chinese therefore meant that this European leg of the dispute has repeatedly been postponed. Now, however, the European front is officially open.     
The list of goods impacted as a result is very large: French wine, Italian cheese and olives, whisky, and cashmere sweaters, among other items. This cannot be good for Europe: its economy is already in stagnation, with some of its largest economies (such as Germanyand Italy) flirting with a recession.  In particular, while Franceand Germany have at least benefited from the positive impact of the aerospace industry to their economies, Italy, which does not belong to the Airbus consortium, would be hit by new tariffs without ever having directly or greatly benefited from the subsidies the company is alleged to have received.
Neither will the US economy remain immune from the expected counter-ruling by the WTO, nor from any retaliatory tariffs that the EU might decide to implement. The American economy is decelerating as the effects of tax cuts are fading out, and the Fed is not following Trump’s game of forcing the central bank to provide monetary stimulus as an (imperfect) offset of the tariffs on various countries that the US government has imposed.
This new European chapter of the American trade war is unlikely to have a happy ending, especially as the most likely outcome for the US-China front of the trade war is not a fully-fledged deal or a total breakdown in negotiations, but rather a continuation of the “controlled escalation” that has been taking place. Unfortunately, the world economy will have to deal with the effects of these disputes for years to come, forcing policy makers to provide fiscal and monetary stimulus, and keeping markets unnecessarily volatile. 

By Brunello Rosa

30 September 2019  

In the beginning there was Minsky. According to Hyman Minsky’s financial instability hypothesis, during the expansionary phases of business cycles, the financial position of economic agents – companies, households, sometimes even governments – becomes increasingly fragile, as they move from relatively secure “hedge” positions towards speculative or, in extreme cases, “ultra-speculative” positions; the latter not dissimilar from infamous Ponzi schemes. In a more fragile environment, even a small shock to the system, such as a small increase in interest rates, has the potential to render the most exposed positions illiquid or even insolvent.  This eventually leads to a downturn in the financial cycle, not dissimilar to the debt-deflation spiral described by Irving Fisher. In turn, this collapse of financial positions triggers a downturn in the business cycle, which moves from expansion to slowdown and eventually into contraction. From a Shumpeterian perspective, this period of “creative destruction” is very healthy, as this process of selection and “survival of the fittest” allows the system to restore itself, shedding previous excesses that existed and therefore readying itself for the subsequent economic recovery.
The particular segment of the business cycle when the cycle turns as a result of a financial shock has been popularised with the name “Minsky moment.” This is considered a real pity by those who are actuallyscholars of the great post-Keynesian economist, as the term completely misses the fact that Minsky’s analysis is a theory of the business cycle: its most interesting part is not the “moment” of shock, but rather is the recovery phase of the cycle, when the financial fragility of the system increases, completely undetected, thus preparing the ground for the later, inevitable downturn. Economic analysis has preferred to focus on the conditions (including shocks) that could trigger these “Minsky moments.” For example, Nassim Nicholas Taleb has written convincingly about “black swans”, extremely rare events that could trigger major changes in prevailing economic, financial and social conditions.   
Moving from theory to practice, press reports recently reported that market participants currently fear many black swans, with a potential spike in oil prices deriving from the US-Iran-Saudi Arabia tensions adding itself to a list that already included a possible collapse in US-China trade talks or UK-EU negotiations regarding Brexit. In his latest column for Project Syndicate, Nouriel Roubini spoke about four collision courses that could derail the global economy, adding to this list the victory by Alberto Fernandez in Argentina’s primary presidential election, which has triggered yet another debt restructuring by the Latin American country.
But the list of these potential triggers could be expanded even further. in the US, an impeachment of Trump ahead of the 2020 presidential race could lead, under certain circumstances, to a severe market correction. In Europe, Germany’s recession could deepen, potentially leading to a government collapse and further political fragmentation. In Italy, Matteo Renzi’s newly formed party could pull the plug on Conte’s government, paving the way for a return of Salvini to power. In Asia, an increase in the Japanese consumption tax could lead to an economic contraction, deepening the global slowdown. And other examples could be made for Brazil, China, Russia, etc.
What about the policy response? In the recent decision by the Fed to adopt “insurance cuts” there is a reminiscence of Minsky’s theory, insofar as the central bank decided not to increase rates further at a time when the economic and financial system seemed already to be fragile – to avoid providing a shock that might have triggered a downturn. After years of experimenting with monetary policy, there is now a great consensus among economists that fiscal policy should take up the responsibility of being the main counter-cyclical policy instrument. In effect, in Minsky’s theory, the policy prescription could be simplified with the expression “Big Government” – in other words, making sure that public expenditure is a large component of national income, so as to stabilize business cycles. As Richard Koo convincingly argued, in a balance sheet recession following a debt-deflation episode, the system needs at least one large borrower that can compensate for the deleveraging of the private sector, and that must be the government. 

By Brunello Rosa

23 September 2019  

There have been a number of rallies around the world this past week, mostly of young people gathering to protest about the inaction of the global élites regarding the devastating phenomenon that is climate change.  Rallies were held in 150 cities, according to event organisers. These took place at the same time as the intervention at the United Nations by Greta Thunberg, one of the moral leaders of this global movement.We have already previously written,in our column in August 2018, about the impact that climate change (or, more appropriately, global warming) could have on a number of economic, financial, political and geopolitical fronts.
Last year we focused our attention on the existing link between climate change and migration flows, as immigration was and still is one of the most divisive political issues in both the US (where President Trump was suggesting to build a wall along the border with Mexico) and in Europe (where the support for populist parties was increasing as a result of the rise of immigration). In this respect, in 2019 the UN has made a giant leap forward in our view, by introducing the concept of “climate migrants”, a term that will be even broader in scope than the initial category of “climate refugees”.
The introduction of this new concept might eventually have very practical political consequences. In their recent meeting in Rome, French President Macron (who is preoccupied by the rise of Marine Le Pen’s Rassémblement National) promised Italy’s PM Conte (who needs to contain Salvini’s propaganda about there being a “migrant invasion”) to automatically redistribute only the asylum-seeker refugees arriving on Italy’s shores, but not the “economic migrants.” But if – in the not-too-distant future – the EU accepted the idea that those who are now considered “economic migrants” (i.e. people supposedly looking for a better life) are in fact “climate refugees” (i.e. people escaping the effects of climate change) then the number of people subject to automatic re-distribution would increase dramatically, making migration an EU-wide phenomenon as opposed to just a “law-and-order” issue for Greece and Italy to address on their own. The sooner this happens, the better.   
Turkey’s Erdogan, who pocketed EUR 6bn from the EU to keep the Syrian refugees in his camps, has threatened to “open the gates” of migrants to Europe, unless the EU gives him more money to deal with this phenomenon. A new wave of migrants to Europe, similar to the 1.1mn people that Germany absorbed in 2015, could destabilise the EU and eventually lead to its implosion.
In this respect, French President Macron is very active, and put climate change as one of the key agenda points of the G7 meeting in Biarritz. Macron suggested to provide financial resources (USD 20mn) to Brazil to help the government led by Bolsonaro to deal with the Amazon wildfires. The two had a lively exchange of views, which unfortunately has not led to a solution. Also in Europe, Germany’s government unveiled a EUR 40bn investment plan in “climate protection measures,” which is thought to be Germany’s vehicle to provide fiscal stimulus to its ailing economy, which contracted by 0.1% in Q2 2019.  
But the fight for climate change will involve also key actors from the financial industry. While the US continues to be on the side-lines of this fight, given Trump’s scepticism over the scientific foundations of global warming, Christine Lagarde (former IMF Managing Director) pledged to “paint the ECB green”  in her inaugural audition before the EU parliament as ECB President. As Lagarde said, the “discussion on whether, and if so how, central banks and banking supervisors can contribute to mitigating climate change is at an early stage but should be seen as a priority.” In effect one of the pioneers of evaluating the impact of climate change for central banking is BOE Governor Mark Carney.
How to combine economic efficiency and productivity growth with the transition of major economic systems towards more sustainable sources of energy should be a key aspect of the new form of capitalism that thought leaders such as Martin Wolfbelieve should start to emerge in coming years, if liberal democracies want to survive.    

 By Brunello Rosa 

16 September 2019  

The world’s major central banks are taking to centre stage again. As we discussed in our review, last week the ECB kicked off the process by announcing a new stimulus plan, consisting of a cut to the deposit rate (accompanied by the introduction of tiered reserves to protect bank profitability), easier conditions for the new TLTRO long-term loans, a promise to keep interest rates at current or lower levels until inflation is closer to target, and new asset purchases that will last until shortly before rates start to be increased. While market participants expected a larger package in some ways, the ECB surprised to the upside by announcing an open-ended version of this easing program: the stimulus will continue until inflation stabilises at a level closer to target. 
This coming week, two other major central banks will hold their policy meetings: the Federal Reserve and the Bank of Japan (BoJ). The Federal Reserve is widely expected to cut its Fed funds target rate further, as part of the insurance cuts it started in July. The real question is what the Fed will say about future rate cuts. The market expects these insurance cuts to be just the beginning of a prolonged easing cycle. President Trump is putting as much pressure as possible on Fed Chair Jay Powell to make sure this is indeed the case. However, the Fed is trying to resist any political interference, including the pressure to cut rates to respond to the increases in tariffs unilaterally decided upon by the White House. The clash between the two is intensifying; the former President of the New York Fed William Dudley openly advised the Fed not to fall into this political game, which only serves the purpose of ensuring Trump’s re-election in November 2020.
On Thursday, it will be the BoJ’s turn: analysts are split as to what the BoJ could do in September, just a couple of weeks before Japan’s planned sales tax increase from 8% to 10%. The BoJ might want to keep some of its ammunition for rainy days, but on the other hand it will not want to fall excessively behind the Fed and ECB in their easing cycles. In Europe, the Swiss National Bank and Norges Bank will also hold their policy meetings this week. Their policy decisions too will be greatly influenced by what the ECB and the Fed have done.   The Bank of England’s MPC, also meeting on Thursday, is also widely expected to remain on hold, waiting for Brexit developments.  
In spite of all of the best efforts to reduce their relevance over time, the contribution of central banks remains absolutely crucial to countries’ policymaking. There is a lot of talk about the possibility of greater monetary-fiscal cooperation, if not explicit coordination. Some are even suggesting that the next step should be “helicopter money”, whereby central banks provide monetary instruments directly to the general public, thus circumventing the banking system. (Recently, key contributions in this direction have been given by Stanley Fisher, Philip Hildebrand, and others). Draghi himself, during his press conference last week, said that “government with fiscal space should act in an effective and timely manner.” But the reality on the ground, so far, is that fiscal policy is constrained, and monetary policy still remains, by and large, the only game in town when it comes to supporting economic activity during the ongoing slowdown. 

By Brunello Rosa

9 September 2019  

The level of recklessness existing in politics has increased remarkably during the past few years. This recklessness has produced unexpected outcomes and dangerous side effects that will impact certain countries for years to come. Examples of this phenomenon can be seen in most of the regions of the world.
Let’s start with the UK. In 2016, PM David Cameron launched a referendum on the UK’s participation in the EU. He made this decision as a way of solving the internal debate taking place within the Conservative party, which had been divided for years over this issue (and still is!). The referendum, only the fourth held in the country in 40 years, did not include any precautionary mechanism that could prevent a small majority from deciding the fate of the entire country and its four constituent nations. One could have included a minimum threshold in the referendum (e.g. requiring at least 55% of votes to validate the outcome), or a provision that would have required a majority vote to be achieved in the referendum within each of England, Scotland, Wales, and Northern Ireland. Instead, the Leave camp won by a narrow 52-48% majority, and the Brexit process was initiated in March of 2017. In the two and a half years since then, the issue has still not been resolved.
Partisanship in the country’s political debate has reached levels not seen in decades. The new Prime Minister Boris Johnson is further radicalising this clash, shutting down parliament and threatening further constitutional stretches in coming days. All this just to increase the stakes in the UK’s negotiations with the EU, to threaten the 27 with a no-deal scenario. This is yet another example of lack of a prudence being taken in contemporary politics. 
Moving over to Italy now, we can see that other notable examples of political recklessness have emerged as well, in recent years. In 2016, Matteo Renzi launched a referendum on his plan for constitutional reform, which was very controversial. As if that was not enough, Renzi said that his political career depended on the outcome of that referendum, thus raising the stakes to the point of risking his entire government. The referendum did not pass. Years of discussions over how to change the country’s constitution were wasted in a single day, and the government collapsed as well, paving the way to the Five Star and Lega victory in 2018. Lega’s Matteo Salvini made the same mistake in 2019: he pulled the plug on a government that was extremely popular at the national level (even if internally divided and quarrelsome).  He bet everything on the fact that the PD and the Five Star would not make a deal with one another, and that the President would call early elections right in the middle of the budget season, thereby risking budget prorogation and market turmoil. All this did not occur, and so he lost power. In this case, this actually removed a risk factor from the political landscape; namely the possibility for Italy to leave the euro area. Nonetheless, the political calculus behind Salvini’s gamble was not prudent, and could have cost the country dearly.  
On the other side of the Atlantic, President Trump was after running a very divisive campaign, a campaign which radicalised the political landscape in the US and reduced the space available for cooperation between the two parties in Congress. After that, Trump started applying his “art of the deal” approach, consisting of assertive moves, veiled and not-so-veiled threats, and brinkmanship, to a number of situations: NAFTA, trade and tech disputes with China, the Iran nuclear deal, etc. This approach has made US leadership less predictable, leaving traditional allies confused. As a result of his trade wars and widespread uncertainty, the world economy has entered a slowdown, which affecting the US economy and risks jeopardising Trump’s chances of being re-elected in 2020. 
In Japan, meanwhile, PM Abe seems willing to spend all of his political capital on a referendum to change Article 9 of the country’s pacifist constitution, even as public opinion remains opposed to such a change. Here too, we see a political leader making a bet that could backfire massively on himself. In this case, the bet is taking place in a country that has been fighting deflation for the last 30 years.
These are only a few examples, from four prominent G7 countries, of the recent increase in political recklessness. Other examples could be given as well, both in advanced economies and in developing countries. Brazilian President Bolsonaro’s approach to the fires in the Amazon, for instance. Maduro and his mis-management of Venezuela. Argentina taking on the largest loan on IMF’s history, only to default on it after one year. North Korea’s development of a nuclear program. The list goes on. In our view, having political leaders who play with fire, as if there were no consequences to their mistakes, is very dangerous. When too many of them act in this same way, global risks increase and risk materialises in unexpected ways, with the result being that potentially catastrophic consequences can be realized following incidents that would otherwise have only minor negative effects.

By Brunello Rosa

2 September 2019 

This week will be a crucial one for determining the fate of governments in Italy and the UK. In Italy, Giuseppe Conte will come back to President Mattarella to announce whether or not he has been able to form a coalition between the Five Star Movement, the Democratic Party, and other smaller parties. As we discussed in our scenario analysis, there are a number of unresolved issues between Five Star and the Democratic Party, including as to what their government’s program and composition would be. Di Maio’s tough speech last Friday(“either the PD accepts these 20 points, or better to vote. And I may add: the sooner, the better”), was widely regarded as an obstacle to eventual solving of the crisis (hence the fall in equity markets and the spike in the BTP/Bund spread). Additionally, there is a Damocles’ sword hanging over the coalition deal; that is, the vote on Five Star’s online platform Rousseau to ratify such a decision. 

Nonetheless, in our baseline scenario, we expect Conte to be able to positively resolve the “reservation” with which he accepted the charge of forming the government. The government would initially be very fragile, as Conte will have a strong political and social opposition to face, as well as a difficult economic condition (GDP contracted in Q2, among other concerns). At the same time, such a government could also count on some powerful allies. The US President openly hoped for Conte to be confirmed as PM. The outgoing European Commission, even with one of its most hawkish representatives (Guenther Oettinger) said it welcomes the possible formation of a pro-European parliament in Italy.  

The new Commission led by Ursula Von Der Leyen made Conte understand that Brussels will close an eye regarding the budget, so long as Italy remains fiscally prudent and moves in the right direction (even if not at the ideal speed). Even the Vatican showed sign of sympathy for the new government, with a short meeting between the Pope and Conte on Friday. So, while the navigation could be bumpy, the government’s ship does not necessarily need to sink if the coalition partners do not fight too much amongst themselves.  

Market concerns are now actually higher for the government in the UK than for Italy, for a change. During the past week PM Boris Johnson obtained from the Queen the possibility to suspend parliamentfor five weeks between September 9th -12th and October 14th, ahead of a new Queen’s speech. As discussed in our analysis, Johnson claims that this is a normal procedure to allow the new government to focus on its new legislative agenda. But the reality is that the decision was made to prevent opponents of Brexit (or at least, opponents of a no-deal Brexit), who are a majority in parliament, to undertake the legislative actions that would prevent a no-deal Brexit from occurring. When parliament reconvenes on September 3rd, after the summer recess, it will now only have 6 days, and even fewer working days, to try and react to this move. 

Though legal challenges have been made against Johnson’s decision, including from the former leader of the Tory party Sir John Major, the possibility that the Labour party will table a no-confidence vote to oust Johnson during this week are much higher now. It is yet to be seen whether this will be a feasible initiative and, if so, whether it will be a successful one. For the time being, markets are skeptical and the pound sterling is reaching all-time lows.  

By Brunello Rosa

27 August 2019  

In spite of the hot weather and the summer holiday season, policy events are in full swing. In the US, the traditional summer meeting of central bankers in Jackson Hole was closely watched, observers attempting to detect signs that would indicate whether the Fed’s insurance cuts could become the beginning of a more prolonged and deeper easing cycle. The words of the Fed’s Chair Jerome Powell were scrutinised, the prevailing impression of them being that Powell remained cautious about providing precise indications as to what the Fed would do in September and beyond. President Trump, considering these words not dovish enough, even asked on Twitter, “who is our bigger enemy, Jay Powell or Chairman Xi?”.  

This question was motivated by the intensification of the trade war between the US and China, with China first announcing tariffs on USD 75bn of imports from the US (itself a retaliation to Trump’s decision to impose additional tariffs starting from September 1st), to which the US responded with a further retaliation. President Trump tweeted that tariffs on the USD 250 billion of imports already in place would be raised to 30% from 25% on October 1, and that the remaining USD 300 billion of imports set to become effective on September 1stwould be taxed at 15%, rather than 10% as had initially been announced.

Another front of the many US confrontations now taking place is Iran. On this front, there might be marginally positive news coming from the recently concluded G7 meeting in Biarritz. Iran’s Foreign Minister Javad Zarif was invited to the side-lines of that meeting. Though President Trump did not meet with Zarif, we can consider it positive news that a channel of communication was opened between the two sides (thanks to French President Macron, who organised the meeting).   

Other items on the agenda of the G7 meeting besides trade wars and tension with Iran included the digital tax that Macron wants to impose on US tech giants in France, and emergency measures to combat the fires in the Amazon forest.  The Amazon represents another very sensitive front in international relations, of course. Brazil’s President Jair Bolsonaro is insisting that Brazil’s portion of the rainforest belongs unequivocally to Brazil – but the rest of the world is claiming that the forest is the “global lungs”. 

Around the table in Biarritz there were key players in two other critical political developments that were cited by Powell as global risks; namely, “the collapse of the Italian government and Brexit”. Italy’s PM Conte – who resigned last week – is waiting to see whether he will be reconfirmed as prime minister in a new coalition government between Five Star and the Democratic Party.  Italy’s President Mattarella will hold a second round of consultations on Tuesday and Wednesday this week. If at the end of this round the possibility of forming a new government is not clear, the President will dissolve parliament to hold early elections, which will most likely take place on November 3rd or November 10th. 

UK PM Boris Johnson made his debut at the G7 in Biarritz meanwhile, and there had the chance to meet again with French President Macron and German Chancellor Merkel, together with EU President Donald Tusk. Johnson re-affirmed his tough stance on Brexit, threatening not to pay the GBP 39bn Theresa May had pledged to pay as part of the Withdrawal Agreement. He is facing a tough return to Britain. When parliament re-opens, he will have to face a no-confidence vote, which could bring down his newly formed government and allow for the formation of a caretaker government that would postpone Brexit and prevent a no-deal scenario from materialising. In response to this threat, Johnson has asked legal advice on whether he can shut down parliament (or, technically speaking obtain a “prorogation”) for five weeks, so as to make sure that no-deal Brexit cannot be blocked by parliament. The EU partners have given the UK the onus to come back to the negotiating table within 30 days with examples of “alternative arrangements” to the Irish backstop, for a deal to be signed. We are clearly going to have to wait until the last moment to find out whether or not a deal is reached. 

By Brunello Rosa

19 August 2019  

We have written several times about the rise of populism at global level, and its repercussion on the political, economic, and financial developments of the countries in which the populist phenomenon is strongest. We have also discussed the potential repercussions for the liberal order and its institutions, such as the European Union, that were created after Word War II as a response to the damage caused by the nationalistic and populist movements of the first half of the 20th century. 

Plenty of studies have been published that discuss the origin of this new wave of populism. A useful taxonomy is one in which contemporary populists have been classified into three categories: those who reached power for cultural or “identity-related” reasons (e.g. Brexit); those who claim to be anti-establishment (e.g. Donald Trump), and finally, those who came to power as a result of a widespread socio-economic malaise (e.g. Five Star and Lega in Italy). In this column we want to focus on the underlying causes of the last of these three categories: socio-economic populism. At the core of any economic malaise there is under-development and lack of opportunity, especially in emerging markets. In developed economies, however, where per capita income is much higher, it is the uneven or unfair distribution of income and wealth that seems to be the driving force behind the rise of populist forces in recent years. 

As discussed in our recent in-depth analysis, income and wealth inequality (or lack of “inclusion”, to use the expression of the IMF/World Bank) is one of the main causes of subdued growth and historically low real interest rates. As the IMF said in its 2018 Annual Report, “reducing inequality can open doors to growth and stability.” Yet by causing subdued and uneven growth, inequality is also a primary origin of protest movements that want to rectify this situation, which sometimes are or have been classified as “populist.”   

In our analysis we discuss how income inequality has been increasing since the 1970s, when the primary distribution of income began to become skewed more towards profits, interests and rents and less to labour.  

At the same time, the neo-liberist revolution of Ronald Reagan and Margaret Thatcher also made the redistribution of income via taxation and subsidies less effective, on the back of what was labelled as trickle-down economics. Many years of increased globalisation, with its inherently deflationary forces (including on wages), reduced labour share of income in the most advanced economies (and parallel increase in the profit and interest share of income), diminished power of trade unions, mass privatisation of public goods, and inability of taxation and subsidies to redistribute income in a fairer way, have led to the current situation. Workers in many countries feel deprived, and are therefore willing to give a chance to political leaders who claim to be on their side, however inconsistent with this claim those leaders’ biographies might be. 

The policy solution to this problem seems quite straightforward: a more active role of fiscal policy, to promote income redistribution, increased public expenditure in infrastructure and education, the provision of job opportunities to younger generations by the public and private sectors. Some of these solutions are becoming popular even among the US electorate, with the rise of political leaders such as Bernie Sanders and Alexandria Ocasio-Cortez, who are not afraid of being labelled “socialists,” a description which just a few years ago would have killed any political career. Nevertheless these solutions are easier said than done. Once in power, even their proponents realise how difficult implementing such policies tends to be, given binding budget constraints. 

Wealth inequality is even harder to assess than is income inequality, as it is often a legacy issue (as wealth is accumulated over generations), and as it is the result of the cumulative effect of income inequality over a long period of time. A group of economists has suggested the adoption of a “wealth tax” as a solution to this issue. This might well be a solution, but the political economy of adopting such a tax would be complicated, and so might ultimately prove to be counter-productive. 

All this is to say that income and wealth inequality are here to stay for the time being, and will continue to feed populist movements around the globe. Policy solutions are available, but their implementation is complicated and sometimes politically toxic. This means that probably things will have to get worse before they can get better.   

By Brunello Rosa

12 August 2019  

Last week, we observed that political risk has been rising again, especially in Europe. In Italy, following months of indecision, Lega’s leader Matteo Salvini decided to pull the plug on Conte’s government by tabling a no-confidence motion in the Senate. As we discussed in our flash update last week, that officially marked the beginning of a government crisis which is expected to lead to a snap election being held in late October. If that election takes place, Salvini – who has asked the Italian voters to given him “full powers” – could become Italy’s Prime Minister by the end of the year. Salvini’s budget plans are certainly not in line with Italy’s budget discipline of the last few years, and therefore Italy is likely to soon be on a collision course with the EU Commission (again!). Markets are already reflecting these developments, with the 10y BTP-bund spread back to 240bps, and equity prices having fallen by 2.5% last Friday. Also on Friday, Fitch kept Italy’s rating at BBB, with a negative outlook, clarifying that a government collapse in H2 2019 was already part of their baseline. As we discussed in our medium-term scenario analysis in October 2018, Italy is now choosing what we labelled an Austro-Hungarian path. This could eventually lead the country to become an “illiberal democracy,” as theorised by Salvini’s maestro, Hungary’s Prime Minister Victor Orban. 

Italy is not the only country to be experiencing a political drama. In the UK, PM Johnson has confirmed that the country is ready to leave the EU with “no ifs and no buts” by October 31st, with or without a deal. He might have been lured into doing so by US assurances that the Trump administration will be at the UK’s doorsteps “pen in hand” to sign a free-trade agreement with the country. 

In fact, such a deal might be difficult to achieve: a number of US politicians with Irish roots would reportedly be very reluctant to ratify any trade deal that risks endangering the provisions of the Good Friday Agreement for Ireland, and in particular the existence of an open border between the two sides of the island. 

Also, former US Secretary to the Treasury Larry Summers said that any trade deal signed with the US after a “no-deal” Brexit would be particularly advantageous for the US (for example, health insurance companies could try to replace the NHS), but very dis-advantageous for the UK, given that the UK may be in a desperate position after crashing out of the EU. (Brexit uncertainty has already caused UK’s GDP to fall in Q2 2019). As a result of all of this, a new standoff between the UK and the EU Commission is likely to begin soon, which might lead to new elections. Press reports suggest these might take place immediately after Brexit, possibly even on November 1st. The effects of the no-deal would then not yet be immediately visible or able to influence voters’ opinion. 

All these domestic political risks are resurfacing at a time when geopolitical risks are also on the rise, and as the global economy is particularly fragile. As we will discuss in greater detail in John Hulsman’s Geopolitical Corner later this week, a few days ago India’s PM Modi reduced Kashmir’s autonomy, and by doing so inflamed a region that is geopolitically one of the hottest in the world (especially given that both India and Pakistan have nuclear military capabilities). Meanwhile the US has decided to rebrand China as a currency manipulator after many years, following the depreciation of the RMB to above 7 US dollars for the first time since 2008. (The RMB depreciation was caused by the threat of new US tariffs on Chinese imports, which we discussed last week). With this move by the US, the risk of a currency war has been added to the ongoing trade and tech wars between China and the US. It should not come as a surprise that all these political and geopolitical risks are taking a tolls on the global economy.  

By Brunello Rosa

5 August 2019  

At the end of last week, US President Donald Trump threatened to impose a 10% tariff on the remaining USD 300bn of imports from China beginning on September 1st, if by that date an agreement is not reached between the Chinese and US governments. After the small level of hope generated from the “positive” meeting between Trump and Chinese President Xi Jinping at the G20 meeting in Osaka, this turn of events makes the possibility of a comprehensive trade deal between the US and China being  reached soon even slimmer than it had previously been. In the days preceding this latest of Trump’s threats, he had warned markets and the general public that China’s tactics might have been to wait until November 2020 before signing any agreement, in the hope that by January 2021 they could deal with a more conciliatory, Democratic president.
Unfortunately, events are unfolding in line with our view that a controlled escalation between the two countries is more likely than a full-fledged deal being reached, and that at best the US and China can only agree on temporary truces during what may prove to be a long-term technological and geo-strategicnew cold war— or Cold War 2, as we labelled it in early May. A comprehensive and long-lasting agreement is hard to envision, even if Trump were to win re-election in 2020. At most, a more prolonged truce between China and the US could be agreed upon, but such a truce would remain fragile and subject to interpretation and controversy.
Needless to say, the market did not respond well to the latest turn of events. Equity market sold off massively throughout the world, reinforcing a move that was already taking place as a result of the disappointment that followed the Fed rate cut on Wednesday 31 July. Long-term sovereign bond yields in US, UK, Europe and Japan collapsed.  In those jurisdictions where the market could expect more rate cuts from central banks, sovereign yield curves steepened. Elsewhere, they continued to flatten. Even in the US, where the Fed has 225bps of easing space available, the 2y US Treasury yield closed the week down by 16bps, while the 10y yield fell by 24bps on the weekly basis. The net result has been a re-flattening of the yield curve, after the marginal steepening that had occurred in anticipation of the Fed’s rate cut.
In the past, a flattening of the yield curve has been associated with upcoming recessions. In our analysis, we have argued that with the long end of the US yield curve being anchored by low yields in Germany and Japan, this correlation between the curve and recession probabilities has diminished. Nevertheless the latest developments do not bode well for the US or the global economy.
To begin with, it would be delusional to think that lower policy rates by the Fed could compensate higher tariffs, which risk having a disproportionate and non-linear effect on the economy.
Second, in addition to the ongoing trade and tech war there are also unabated tensions with Iran, which have recently escalated with the seizure by Tehran of a UK super-tanker. This stand-off is likely to be prolonged; the Iranian government might wait for the end of Trump’s presidency before re-opening the diplomatic channels of communication, in the hope of dealing with a less confrontational US president.
Finally, as the global manufacturing recession continues, the global economy might be on the cusp of a downturn which looser monetary policy alone might be insufficient to avert.  

By Brunello Rosa

29 July 2019  

Last week, Boris Johnson was elected leader of the Conservative Party and, as a result, Prime Minister of the United Kingdom. Johnson’s program has the acronym DUDE: Deliver Brexit, Unite the UK, Defeat (Labour’s leader) Jeremy Corbyn, and Energise Britain. His first speech, made  in front of 10 Downing Street, was a profusion of optimism; it was an attempt to rally the country’s sense of pride over its glorious past and purported luminous future outside the EU. Johnson promised to take the UK out of the EU by October 31st, “no ifs and no buts.” Polls show that this new, energetic and defiant approach has resulted in a 10% bounce in the Tory support, to 30%, ahead of Labour (25%), LibDems (18%) and the Brexit party (14%).
The largely reshuffled cabinet reflects this new, assertive approach to Brexit. Leading Brexiteers have been given key ministerial roles. Dominic Raab is replacing Jeremy Hunt as foreign secretary, Andrea Leadsom is replacing Greg Clark as Business secretary, Jacob Rees-Mogg (the Chairman of the ultra-Brexiteer European Research Group) is replacing Mel Stride as Leader of the Commons (which organises the government’s activity in the House of Commons), Michael Gove is replacing David Lidington (Theresa May’s de-facto deputy PM) as Chancellor of the Duchy of Lancaster and key adviser to the PM, in charge of coordinating Cabinet activity. Additionally, former pro-Remain Sajid Javid is replacing Philip Hammond as Chancellor of the Exchequer, and is preparing an extraordinary budget to speed up preparations for a no-deal Brexit. Finally, political strategist Dominic Cummings, the former campaign director of “Vote Leave”, is now special advisor to the PM.
In a series of updates, we have discussed what consequences the election of Boris Johnson could bring about. Regarding Brexit, Johnson’s attempt to renegotiate the deal with the EU will at first likely result in a firm “no way” from the EU. That could in turn trigger a confidence vote that, if lost by Johnson, could result in a Labour-led minority government being formed, a new general election being held or even a second referendum. In case of new elections, a tactical Tory alliance with Nigel Farage’s Brexit party would become likely.
Such an outcome would change the nature of British politics: by making an alliance with Farage, the Conservatives, one of the cornerstone parties of the UK political system, would be institutionalising the populist movement (which morphed into a party at the latest EU elections) that has led to Brexit. In other European countries we have seen how fringe national-populist parties have come to power by making alliances with the traditional, mainstream parties (for example in Austria, under the government of Sebastian Kurz). Once contracted, the virus of populism is very difficult to get rid of: it tends to become part of the political discourse, and never fully leaves. A seemingly endless list of countries all around the world, from Latin America to Europe and Asia, know this all too well. What is astonishing to watch is the US and UK, countries that were leaders of the liberal-democratic order that was born after World War II, entering such a difficult phase of their history as well.
We believe a period of political turmoil is likely to begin for the UK. The Brexit plane is not going for a soft landing. In the best case, it is going to be a very bumpy landing – but no one can rule out a crash either. The key point to understand here is that what seems a failure to most of the international observers, including us, might not be perceived as such by the new Tory and British leadership. In the next article for his Geopolitical Corner published this week, John Hulsman will discuss in detail how Johnson perceives the Anglosphere to be his geo-strategic horizon, and this does not require any participation in the European integration process, which is perceived rather as a chain to be freed from.   

By Brunello Rosa

22 July 2019  

This week, the long-awaited period in which G10 central banks start becoming more accommodative will begin, starting with the ECB’s Governing Council meeting on Thursday. As we wrote in our preview, the ECB will mostly just be laying the groundwork for more significant easing measures to be adopted in September, when a new set of staff forecasts will also be provided. It may, however, also give something of an appetizer in July, in terms of beginning the process of accommodation immediately to a certain extent. Currently markets remain buoyant about the arrival of Christine Lagarde at the helm of the ECB, as she is expected to provide continuity with Mario Draghi’s era. Additionally, press reports revealed that the ECB is looking at the appropriateness of its official goal (to keep inflation “below, but close to 2%”) to achieve its price-stability mandate. These reports suggest that a more “symmetrical” approach would provide less of a disinflationary bias and more headroom for an easier policy stance.
Similar thinking seems to be underway in the US, where the Fed (whose FOMC meets next week) appears to be on the verge of moving de facto to some form of average inflation-targeting regime, suggesting that after a prolonged period of target under-shooting, monetary policy could be kept more accommodative than is justified by the stage of the business cycle alone, in order to make up at least part of the miss in the price level. As a result of these considerations, the recent testimony by Chair Jay Powell before the US Congress, and a speech by the President of the New York Fed John Williams (which required an unusual clarification), market expectations about the size of the rate cut in July have swung wildly in the last few weeks, between 25bps and 50bps. After this period of volatility in expectations (amounting to “confusion,” according to some press reports), they seem to have stabilised at 25bps. We will discuss all of this in greater detail in our upcoming preview for the FOMC meeting.
The same week as the Fed meeting, the BOJ and the BOE will also hold policy meetings. As discussed in our recent overview of the policy stances of the G10 central banks, the BOJ could start making the first changes in its language as early as July, whereas the BOE will remain mostly reactive, with the change in the British government and Brexit developments dominating the macroeconomic environment. Other G10 central banks, such as the RBA, RBNZ, and BOC, have already acted or adjusted their rhetoric in response to these developments. But some other central banks, such as the Riksbank, have expressed more caution, in consideration of the more limited easing space available to them. On the other side of the spectrum, Norges Banks has, so far, remained fiercely hawkish.
G10 central banks tend to set the pattern for all other central banks in the developed world (e.g. in South Korea, the central bank cut its policy rate for the first time in three years), but also in Emerging Markets. An easier stance in the G10 reduces the pressure on EM central banks to keep rates high to sustain their currencies and contain inflation. A number of EM central banks have already cut rates in recent months as a result of this changed landscape, including in China, India, Russia, the Philippines, and Malaysia.
Now the time seems ripe for even the embattled Central Bank of Turkey to cut rates, after the defenestration of its Governor by President Erdogan. At its meeting on Thursday 25 July, the TCMB is expected to cut rates by a whopping 250bps, from 24% to 21.5%, in a supposed sign of normalisation after the defensive hikes it adopted at the height of the Turkish Lira crisis during the summer of 2018.ns (amounting to “confusion,” according to some press reports), they seem to have stabilised at 25bps. We will discuss all of this in greater detail in our upcoming preview for te FOMC meeting. 

by Brunello Rosa

15 July 2019  

Last week, when we commented on the selection of the new heads of the top five EU institutions, we highlighted how the end of the musical chairs game that the selection process resembled delivered only a very a fragile political equilibrium. We also took a non-consensus view of the situation, arguing that time is on the side of the national-populist parties in Europe, which, during the five-year tenure of this new parliament, will have the option of making a proposal to the European People’s Party (EPP) to form a coalition together. Already during the past week, events of this kind have been unfolding more rapidly than even we would have expected.
As numerous press reports suggest, the new EU Commission (EC) President Ursula Von Der Leyen is having a hard time securing the votes she will need on July 16thif she wants to win a vote of confidence from the EU Parliament. With the far-left GUE and the Greens having formally announced their vote of no confidence towards President Von Der Leyen, she now needs to rely on a three-party coalition of EPP (179 seats), Socialists & Democrats (153 seats) and Liberals (105 seats). Theoretically speaking, this ruling coalition could count on 437 votes, much more than the 374 necessary to reach a majority in the 750-seat European Parliament. 
However, a number of MEPs, especially those from the German Social Democrats, are still upset by the method by which Von Der Layen was chosen (in particular, the trashing by French President Macron and German Chancellor Merkel of the Spitzenkadidat system that was introduced in 2014). Others are unimpressed by the lack of ambition of her political program, which so far seems to be just a sensible continuation of the status quo. Additionally, some members of the EPP, such as Viktor Orban’s Fidesz, want a softer stance taken by the future EC regarding the application of Article 7 (namely, the sanction imposed on misbehaving countries) in exchange for their vote. So, what seemed to be a vote that Von Der Leyen could take for granted could instead become extremely problematic. 
Facing this situation, it was suggested to her to postpone the vote to September, so that she could gain more time to convince the rebellious MEPs to give her their support. But she understood that nothing would change in the next two months, and that her position could become even weaker if she were to let this situation fester for a longer period of time. 
But here is where the situation becomes intriguing, if perhaps also dangerous. A number of populist-nationalist parties have offered their support to Von Der Leyen, in exchange for a more favourable attitude taken by the EC President on the dossiers close to the various party leaders. PiS, the Polish party of the nationalistic leader Jarosław Kaczyński, has offered its support in exchange for a softer stance on the application of Article 7, like Hungary’s Fidesz. Lega and Five Star have offered their votes in return for a “heavy” portfolio for Italy in the new EC, such as Competition, or Industry. 
Von Der Leyen might manage to convince the rebellious MEPs from her own coalition to fall into line and allow the Commission to have a working and cohesive majority from the start of her term. But she might not have enough time for that. In that case, she may be forced to accept parties to allow for the birth of a Commission presided over by herself. Such a Commission would become vulnerable to the requests of the national-populists sooner than even we had anticipated. Von Der Leyen’s manoeuvring space to reform Europe in the direction of the “United States of Europe” (the way she reportedly would like to see the EU  become) would be further reduced. As a result, the process of EU dis-integration would likely accelerate further in coming years. 
If Von Der Leyen fails to reach a majority this week, this would open up a serious institutional crisis in the EU, forcing EU leaders to find another solution. Such a solution is difficult to identify, as Von Der Leyen was chosen as part of a “package” that is difficult to unbundle, a package which also included the selection of David Sassoli who has been already elected President of the EP, Charles Michel as President of the EU Council, and the arrival (which markets have already greetedpositively) of Christine Lagarde at the helm of the ECB.  

By Brunello Rosa

8 July 2019  

We have been following the “musical chairs” game that was the selection process for the EU’s top jobs since January 2018, when it began, well before it attracted the attention of investors, market participants, and a wider audience informed by the media. We followed its evolution closely; we noted, for example, when Mario Centeno was appointed as head of the Eurogroup in September 2008, and continued to monitor the selection process until its recent, final rush, which began with the Special EU Council meeting on June 30th. On July 2nd an agreement was reached that included the following appointments: EU Commission (EC) President: Ursula Von Der Leyen (Germany, CDU); EU Council President: Charles Michel (Belgium, Liberal); European Central Bank (ECB) President: Christine Lagarde (France, formerly EPP); EU Parliament (EP) President: David Sassoli (Italy, S&D), who will most likely serve half of the 5-year term (as usual convention); and EU High Representative (HR) for Foreign Policy: Josep Borrel (Spain, S&D).

As we said in our recent in-depth analysis of the European leadership selection process, our overall impression is that the outcome of this lengthy musical chairs game could have been worse. After all, the chosen leaders are all political heavyweights, and the main criteria to achieve a political equilibrium within the EU have been respected (with the exception of the Union’s East-West criterion, mostly because Eastern European countries were identified with the Viségrad group, which positioned itself in opposition of the solutions proposed by France and Germany). The fact that Germany will lead the Commission directly means that the country is taking direct responsibility for what takes place in the EU in the next five years. Even if Germany intends to slow down the Union’s integration process, it will still not oversee the collapse of the European project. At the same time, a high-profile French policymaker, Christine Lagarde, has been given responsibility for providing the liquidity that might prove necessary to the EU in moments of crisis. Germany could distance itself from the more radical choices the ECB might take under her leadership (as Germany did previously, with Draghi), while still benefiting from their results.

With the selection of Von Der Leyen and Lagarde, Germany and France are personalising  their joint commitment to on the continuation of the European project. This is a plus, especially if means that they will be willing to put their money on the table, so to speak, in terms of increased risk-sharing (something Germany always opposes) and additional sovereignty transfers from the national level to EU institutions (something France always despises), to ensure the project can be maintained. 

Together with these pluses, there are the minuses. First, the entire selection process has exposed once again how messy EU policymaking is, and how ugly it is to watch for the average EU citizen. Second, the compromise reached today is the result of the internal political equilibria that exist currently within the various EU countries. But these politics may change a lot, as elections in Germany (2021), France (2022) and most likely Italy are going to be held before the end of this EU parliamentary term. Third, as we said in previous analysis, with all the mainstream parties now lumped together at the EU level, it will be easy for the populist parties to blame the mainstream parties for whatever goes wrong in the next few years. 

And a lot could go wrong in the years ahead, including: 1) a recession is very likely to occur. We can see already the ECB preparing the ground for renewed easing in coming months. 2) Germany is in the middle of a challenge to its business model, deriving from trade tensions and the overhaul of its banking system; 3) Brexit is a process yet to be finalised (with a likely showdown by the end of October), and the UK is likely to enter a technical recession from Q2; 4) In Greece, the victory of New Democracy in the general election marks the end of the post-crisis era, but also the return to power of the party that caused the Greek crisis in the first place. 

Thus, it is very likely that the EU, Eurozone and Europe in general will face an existential threat in coming years. The people at the helm of the EU institutions are equipped to face it. The real question is whether they will actually have the needed political support and mandate to solve it.  

By Brunello Rosa

1 July 2019 

The truce agreed to by US President Donald Trump and Chinese President Xi Jinping at the G20 meeting in Osaka is a welcome development, but it does not resolve any of the underlying issues that exist between the two sides. 

According to press reports, the US will now refrain from imposing additional tariffs on Chinese exports to the US, and will allow US companies to sell their products to the retail section of Huawei’s business.  The Chinese will buy more US agricultural goods. The two sides also agreed to resume the talks that were abruptly interrupted on May 5th, talks aimed at possibly reaching an agreement in coming months. As President Trump tweeted, however, he is “not in a hurry,” since the quality of the deal is more important than the speed at which a deal can be reached. 

In advance of this truce, market participants had already largely been expecting this sort of outcome, in which no deal was reached, yet neither did a complete collapse of the negotiations occur, rather a generic commitment to resume talks was made, with the goal still being an eventual compromise that both sides would consider more advantageous than the status quo. We also expressed this view, but warned that the most likely way forward is not that eventually a long-term agreement will easily be reached, but instead a controlled escalation take place, which in turn will lead to another temporary truce, as part of a larger geo-strategic confrontation between the United States and China that will last for decades. 

In fact, Trump will not want to reach a deal until he has secured at least two, if not several, precautionary rate cuts by the Federal Reserve, ahead of the November 2020 Presidential election. 

He also still has to evaluate what type of rhetoric towards China the American voters will want to hear ahead of the election. It may be that, tired of the economic effects of these prolonged trade tensions, the American voters that Trump is trying to mobilise will be attracted by moderate language on China, suggesting the possibility of a compromise between the two countries being reached soon. 

Conversely, an angry working class that is deeply disappointed by the continuous disappearance of jobs and factories will want to hear incendiary rhetoric against China yet again, portraying China as the cause of all America’s economic troubles. Trump will want to keep all options open until well into 2020, to consider how events unfold in coming months. 

But keeping all options open will also come at a huge economic cost. The option value of waiting for a resolution to US-China negotiations is leading many big businesses to a sort of “investment strike”, which is already weighing on economic performances in the largest, most advanced economies, such as the US, Germany and Japan. 

The ongoing balkanization of global supply chains will have an impact on companies’ cost structure irrespective of whether a trade deal will eventually be reached or not. As such, the real risk is that the damage that will be inflicted upon the US and world economy by this Cold War 2 and its various components (the trade war, technological competition, disruption of supply chains) is larger than is currently being estimated, and that a few cuts by proactive central banks will therefore not be able to prevent a global recession from occurring in 2020-21. 

Thus, even if after the G20 meeting a few people around the world breathe a sigh of relief, the reality is that the underlying problems that exist between the two countries remain mostly unresolved. As fiscal policy remains largely constrained, once again[js1] central banks will have to be the first line of defence against the ongoing synchronised global economic slowdown.    

By Brunello Rosa

24 June 2019  

Last week, Facebook unveiled its plan to introduce a new means of payment for small transactions, called Libra. Although many of the details about it have yet to be revealed, some comments seem warranted based on what we know already. As far as we know, Libra, which will be backed by existing centralised payment systems such as Visa, Mastercard and PayPal, is not a crypto-currency. Facebook itself labelled it a “stable-coin” for this reason. Additionally, as persuasively argued by Nouriel Roubini and other leading economists, crypto-currencies are not currencies insofar as the volatility of their exchange rates with conventional currencies such as the US dollar does not make them a safe store of value, which is one of the key characteristics of money. At most, crypto-currencies can be considered as highly speculative, crypto assets. 

It is unclear for now how “regular” money will be transferred into Libra wallets, at what rate of exchange such transfers will occur at, or whether consumers will be charged a fee whenever they do so. But let us assume that at some point all 1.7bn people on Facebook will have a Libra wallet. That would be a momentous feat, at least in terms of the scale of such an operation. And it would be just the latest arrival with in an increasingly crowded space, in which non-financial corporations are entering en masse into the traditional space occupied by financial companies. Other examples of this include Apple Pay, Ali-Pay, We Chat Pay, and  Amazon’s loans to sellers on its own platform. 

It is now time to take stock of these developments, and assess some of the potential risks that could come along with some of the purported advantages for the consumer, such as reduced fees for small transactions. The fact that the private sector creates money is not cause for concern, nor is it anything new. Most of the money we use – which, incidentally, is already largely electronic, even if not “digital” – is created independently by commercial banks rather than by central banks, the latter of which maintain the monopoly to issue high-power money (the so-called monetary base). 

Banks creating money via their loans are however subject to strict prudential regulations, which establish that there needs to be a relationship between the deposit held and money created. Banks have a lender of last resort, the central bank itself, which has its own international lender of last resort, the Bank For International Settlements (BIS). Deposits at commercial banks enjoy a public guarantee (in Europe, it is up to EUR 100,000 per current account), and banks enjoy an implicit backstop by their sovereign (hence the too-big-to-fail problem, when the individual financial institution is much larger than the sovereign that is supposed to provide the backstop for it). None of these implicit and explicit guarantees will be available for Libra and other forms of digital currency. Who is going to police against fraud, or against money laundering activities, for example? If something goes terribly bad, who will be the ultimate lender of last resort? 

We are entering a dangerous territory here from the perspective of financial stability. For these reasons, leading regulators such as the BIS itself have started to give their warnings about the subject. As Mark Carney, Governor of the Bank of England and former President of the Financial Stability Board, reportedly said, If Libra is successful in attracting users it would “instantly become systemic and will have to be subject to the highest standards of regulation.” 

We are registering here the dramatic increase of offers of new forms of money, means of payments, etc., by private-sector participants, more often than not from non-financial corporations, clearly aimed at disintermediating the traditional channels dominated by banks. This is nothing new: during the eighteenth and nineteenth centuries, plenty of corporations issued their own private forms of payment. That proliferation was at the origin of some of the worst scams and financial instability episodes (for a collection of which, read “Manias, Panics, and Crashes”, the masterpiece written by Charles Kindleberger). The final users of such products, excited by what seem to be “innovations,” should remember these historical precedents when embracing these newly offered means of payment. 

By Brunello Rosa

17 June 2019  

In our latest Market Update and Outlook, published last week ahead of the upcoming quarterly asset allocation, we reviewed the major macroeconomic, political, geopolitical and market events of the last six months. We then provided an outlook for the next six and next twelve months, as well as further ahead in the future. 

From a macroeconomic perspective, the last six months have seen a synchronised deceleration of the global economy, starting from its three main regions (US, Eurozone and China), in spite of upward surprises in Q1 GDP growth. The ongoing trade and tech war between US and China, which is likely the beginning of a new Cold War, which we called Cold War II, is taking its toll on the global economy. The US and China (ahead of a possible truce, yet short of a full deal that would resolve their economic disputes) are importing less from each other, which is likely to benefit only a few select economies, such as Vietnam, Taiwan, Chile, Malaysia and Argentina. In our recent analysis we discussed why we believe that a controlled escalation, or contained commercial warfare, is more likely for the time being than a full-scale trade war or a full deal being reached between the two countries. 

But trade wars, tech wars and the disruption to global supply chains is not the only factor affecting the global economy. Geopolitical tensions are on the rise irrespective of trade tensions (with the US still being the instigator of these tensions). We discussed the risk of miscalculations and accidents taking place in the US-Iran standoff, and last week there was indeed an attack on two oil tankers in the Gulf of Oman, the gateway for over a third of the world’s shipped oil. Even if the situation in the region is set to remain tense for some time, oil prices still fell on a weekly basis, in response to the slowdown in the global economy. Also in the Middle East, the Turkish government confirmed its S-400 arms deal with Russia, after Turkey’s Defense Minister stated that “the language used in a letter sent by the US regarding Turkey’s removal from the F-35 fighter jet program does not suit the spirit of alliance".  

Finally, the regional geopolitical mess that is Brexit, with its potential global implications (the Fed quoted it among the most relevant cross-currents recently weighing on market sentiment), could deteriorate further, if the UK were to go for a no-deal exit following the arrival of the country’s new prime minister (Boris Johnson is the frontrunner). In fact, last week the House of Commons rejected (with a 309-298 vote) a motion designed by the opposition intended to block a “no-deal” exit on October 31st. 

With all of this taking place, and as fiscal policy remains constrained, central banks are already on the move. Joining the Fed, ECB, PBoC and BOJ, the Swiss National Bank (SNB) also claimed last week to have room to further ease its policy stance, and, also for this purpose, introduced its own SNB Policy Rate, in substitution of the 3m Libor target range. This week, the Fed will provide further indication as to whether or not it wants to proceed with its precautionary cuts, which the market now considers certain to be implemented by year end, considering the various cyclical and structural factors dampening upward pressures on US inflation. At the same time, Norges Bank will likely confirm that it will remain at odds with all other G10 central banks, and will likely proceed with its pre-announced 25bps increase in its policy rate. 

After a very volatile semester, the price of risky assets (primarily equities) and the price of long-dated government bonds are supported by this renewed dovishness of central banks. However, if the damage to the global economy proves to be larger than is currently estimated, central banks will have to do much more than a few insurance-based cuts to prevent a recession and severe market correction in the next few months.  

By Brunello Rosa

10 June 2019  

The global economy is now in the middle of an asynchronous slowdown, which is occurring mostly as a result of prolonged, intensifying trade tensions, rising geopolitical risks, and tightness in the labour market in a number of countries. Let us briefly examine the three major economic regions of the global economy. 

In the US, Q1 GDP growth was surprisingly positive, but domestic demand weakened substantially, providing little comfort for the economy’s future performance. The non-farm payrolls figures for May 2019, released last week, were weaker than expected; only 75,000 jobs were added, as opposed to the consensus expectation of 185,000  jobs or the previous reading of 224,000 jobs. This weaker figure was accompanied by slower growth in average hourly earnings: 3.1% y/y, versus a consensus expectation and previous reading of 3.2%. In a recent interview, Fed’s Vice-Chair Richard Clarida said that tariffs are expected to have a one-off effect on price levels, but a more lasting impact on economic activity. Therefore, if trade tensions do not subside, the negative demand shock to the economy from those tensions will eventually be larger than the negative shock to supply. 

In the Eurozone, Q1 GDP also surprised mildly to the upside, but the latest ECB projections suggest that economic activity will decelerate in Q2 and Q3, so the much-hoped for rebound in Q2 is unlikely to materialise. This is mostly because the largest European economy, Germany, is fighting to exit a prolonged period of stagnation (it has been flirting with recession), while the third largest Eurozone economy, Italy, has temporarily exited its technical recession in Q1 but risks entering a new one in Q2 2019. For the time being, France and Spain are the main drivers of economic growth in the Eurozone.  

In China, the policy stimulus of 2018 allowed the economy to also surprise to the upside in Q1, but the reignition of trade tensions this year have meant a new slowdown, which the authorities are fighting with fiscal, monetary and regulatory stimulus. Going forward, US tariffs are expected to continue weighing on exports and push inflation higher. All other regions in the world closely depend on developments from these three economic and geo-strategic giants, so economic activity is likely to decelerate globally. 

Facing this situation, and waiting for fiscal policy to provide a larger counter-cyclical contribution (even as most government are busy “fixing their fiscal roof” now that “the sun is still shining”), central banks have already begun to act. In a number of jurisdictions, monetary policy, which had at least had a tightening bias, has now become neutral if not overtly more accommodative. In developed markets, last week the Reserve Bank of Australia cut (after a long debate) its main policy rate to a record low of 1.25%, following the neighbouring RBNZ by a month. 

During its latest press conference, President Draghi said that the ECB’s Governing Council has discussed possible easing measures. While the BoJ has never abandoned its accommodative stance, the elephant in the room is clearly the Fed. The markets now price in the likelihood, indeed almost the certainty, that the Fed will cut rates in coming months. In Emerging Markets, central banks have been even more proactive. In China, the PBoC Governor announced “there is tremendous room to adjust monetary policy if the trade war deepens.” In India, a marked slowdown in the economy led the Reserve Bank of India to cut interest rates by 25bps (to 5.75%) for a third time this year, and suggest further cuts are in the pipeline. The central banks of the Philippines and Malaysia also recently cut their policy rates by 25bps, to 4.5% and 3% respectively.    

By Brunello Rosa

3 June 2019  

From the beginning, the ill-designed Brexit referendum has intoxicated the UK’s political system and introduced an element of uncertainty into the country’s constitutional arrangements. In a parliament-centred political system such as the British possess, the source of legitimacy for political decisions rests squarely with Westminster (notwithstanding a strong role for the Prime Minister). From a purely procedural standpoint, then, simply labelling the Brexit referendum as “advisory” and non-binding might have saved the day. Unfortunately, since the day after the referendum its result has been considered politically binding on both sides of the political spectrum, which has committed to “deliver Brexit.”

The inability or unwillingness by Parliament to ratify the Withdrawal Agreement negotiated by Theresa May with the EU has made manifest the constitutional short-circuit that has taken place, as the primary source of legal and political legitimacy is now countervailing the “will of people” as  expressed in the referendum. 

The birth of the Brexit party led by Nigel Farage, and its first-place finish in the European election held on May 23rd, is a response to this inability by Britain’s parliament to deliver Brexit. The Tory party will try to respond to the rise of the Brexit party by choosing its new leader from the camp of Brexiteers, with different degrees of radicalism ranging from Boris Johnson to Dominic Raab and Michael Gove. At the same time, Farage might be tempted to “finish the job”, forcing a split in the Conservative party between pro-Europeans and Brexiteers and becoming the leader of the right-wing of Britain’s political spectrum.  

The British results of the European election has other implications as well. First, both parties entangled in negotiations (Tory and Labour) lost a large portion of their votes. Second, those parties in favour of Remain (chiefly the Lib Dems and the Greens) did very well, and if we sum their votes, they represent a larger proportion of the electorate than does the Brexit party. 

Moreover, a recent poll by YouGov shows that the Lib Dems would be the leading party in the UK if an election were to be held today, ahead of the Brexit party, the Conservatives, Labour and the Greens. If that poll is correct, Brexit would have made the unthinkable happen: a traditional two-party system governed by a first-past-the-post electoral law would become a messy four-party system with the major parties having only between 19% and 24 of the votes. Elections would become completely unpredictable, unless the four major parties coalesced ex ante into pairs (Labour-Lib Dem; Tories-Brexit). Alternatively, all parties might eventually break up and allow a new centrist formation to emerge and take control of parliament and the Brexit process. Such an outcome could lead, potentially, to the Brexit decision being reversed. 

During his visit to the UK, US President Donald Trump could not resist the temptation to make things even more complicated, with his suggestions that Boris Johnson should be the new Tory leader, Nigel Farage should be involved in negotiations with the EU, and the UK should throw out the deal agreed to by Theresa May with the EU and aim instead for a hard Brexit, without paying the GBP 39bn owed to the EU in the coming years. Trump might not have considered that the UK is much smaller than the US is, and that the EU has so far had the upper hand in negotiation, in part because Article 50 is designed to punish the leavers. 

by Brunello Rosa

27 May 2019  

Last week we discussed the European election, which took place between Thursday 23 and Sunday 26 May. The voter turnout for the election, at above 50 percent, was the highest in the last 20 years, testifying to this election’s importance. According to the preliminary results, most of the predictions made in advance of the election (by us and by others) are proving to be correct. The European People’s Party (EPP), will remain the largest group in the European parliament, with around 180 seats, but will lose more than 40 MEPs compared to its results in the previous election in 2014. The Socialist and Democratic (S&D) Party will be the second largest group, with around 150 seats; it too will have close to 40 fewer MEPs than it had in 2014. Conversely, the Liberals of ALDE and the Greens will both gain seats, going from 68 to more than 100 and from 52 to around 70 respectively. This means that in order to form a 376-strong majority, the EPP and the S&D will have to coalesce with the Liberals. (The Greens seem not to be necessary at this stage). 

What about the “national-populist” parties? The ENF group of Italy’s Salvini and France’s Le Pen will increase the number of its MEPs from 37 to around 60. The EFDD group of Farage’s Brexit Party and Italy’s Five Star will also rise, from 41 to around 60 seats. The ECR’s group of UK Tories, Poland’s PiS, Germany’s AfD and Finland’s True Finns will fall from 75 to around 60, mostly because of the UK Tories’ debacle. These groups together will not yet be big enough to make an offer to the EPP, but they will increase their influence in future decision-making processes. 

The press and most “mainstream” policymakers will probably take an unwarranted sight of relief following this election, as they will think that the “national-populist” parties have been kept at bay. We believe this view might prove to be incorrect, for two reasons. 

First, these elections are forcing increasingly unnatural alliances to be made at the European level. The fact that the Liberals may now be in the same camp as the EPP and S&D means that they will all be jointly blamed for anything that can and probably will go wrong in coming years, thereby leaving the national-populist parties (and perhaps the Greens) as the only remaining alternative. 

Second, some of the individual national-populist parties actually fared exceptionally well in these elections. In Germany, the CDU and SPD combined lost more than 18% of the vote, in favour of Greens (now Germany’s second largest party) and AfD (now its fourth largest party). In France, Le Pen’s National Rally Party has reportedly overtaken President Macron’s En Marcheparty. In Italy’s Salvini’s Lega is the first party with 34% of votes having overtaken the Five Star (collapsed to 17%). In the UK, the Brexit Party has gathered around 32% of votes, is the largest party in this election and will certainly campaign for an eventual hard-Brexit solution. In Poland and Hungary, PiS and Fidesz respectively remain the parties that received the most votes. 

Elsewhere, in Greece, New Democracy has reportedly overtaken PM Tsipras’ SYRIZA, and is getting ready to get back into power with the national elections of June 30th.

Thus, the parties forming what we have labelled the “Populist International” are still gaining ground. They know that the race to political power is a marathon, not a sprint. From their new, more powerful positions in EU politics, they will strongly influence the process of appointing the new heads of the EU Parliament, Commission, Council and, above all, the ECB. They will also be likely to have a greater say regarding the overall fiscal and monetary policy stance taken at the EU level. Overall, then, we continue to think that 2019 will be a crucial year for European politics. This EU election is likely to prove an inflection, if not a turning point, in the region’s affairs.

by Brunello Rosa

20 May 2019  

All EU states will hold elections for the European Parliament this week, between Thursday May 23rd and Sunday May 26th. The EU Parliament will be completely renewed, with all 750 seats up for grabs. Because the UK will still take part in this election, the number of MEPs elected will not fall to 705, as had been planned to occur until the UK asked for its first extension to the Article 50 process in late March.

We have already discussed the importance of this election in a number of publications, particularly as a result of the increase in the share of seats that “populist” parties are expected to win. In our paper on the rise of the Populist International, we anticipated how these populist parties might eventually increase their power during this parliamentary term if an economic and financial crisis were to shatter the alliance between the European People’s Party (EPP), Socialists, Liberals, and, perhaps, the Greens, which is expected to emerge following the elections this week. In order to achieve that, the populist parties will have to make an agreement with the EPP, as, for example, has occurred in Austria, where the EPP’s Chancellor Sebastian Kurz is allied with FPÖ’s Heinz-Christian Strache. They would do this by making use of the presence of populist, authoritarian, or nationalistic parties within the EPP, such as Victor Orban’s Fidesz (which has been temporarily suspended from the EPP for its anti-Juncker campaign in Hungary). 

In this respect, there have been very interesting developments, recently. A couple of weeks ago, Orban himself declared several weeks ago that he will not support the EPP’s candidate for the European Commission presidency (so-called Spitzenkandidat) Manfred Weber. This could be a signal of an initial rupture between Fidesz and the EPP, which would have the effect of making the EPP smaller yet less “compromised” by populist parties. On the other hand, a rupture of this kind would also make the group of populist parties larger in the new EU Parliament. This week, the Austrian government itself collapsed after the release of a video showing Strache dealing with supposed intermediators of Russian interests.

So, the future of the EU is at stake in this election. But the election’s importance is not only limited to its historical and geo-strategic significance. The implications for future European policymaking have been discussed at length in a series of papers we wrote about the ongoing European musical chairs game, in which all the most important EU positions will be filled in coming months, including the presidencies of the EU Commission, Council and Parliament and, most importantly for financial markets, the ECB. 

The choice of who heads these institutions will make it clear what fiscal policy stance the EU will take; crucially, at a time when tensions over Italy’s deficit and debt are re-emerging. Consequently, this will determine what the ECB will be asked to do to support the fragile and uneven expansion of the Eurozone economy (which is now slowing down) or to save the euro area from a possible breakup when the next crisis hits (as the ECB did previously during the crisis of 2011-2012).

As usual, these European elections will also be read with a domestic lens within all of the EU countries. In Germany, they could mark the end of Angela Merkel’s tenure as Chancellor (in favour of her successor as CDU leader Annegret Kramp-Karrenbauer), especially if Merkel decides to lead the EU Council. In France, Macron will need to convince his electorate that he can still win more votes than Marine Le Pen’s party (now re-named Rassémblement National). 

In Italy, this election will be a referendum on Salvini’s leadership, and could mark the collapse of the fragile M5S-Lega coalition. In the UK, where the participation in this election is considered a national humiliation, these elections will probably mark the departure of Theresa May from Number 10 Downing Street in the coming weeks, whether Brexit is delivered or not.

by Brunello Rosa

13 May 2019  

Last week we discussed the renewed trade tensions between China and the US. We feared that President Trump’s threat to increase the tariffs imposed on all goods imported from China to 25% would eventually materialise (reportedly due to China backtracking on a number of commitments made in previous stages of the negotiations) – as in fact did occur. These trade skirmishes might still lead to an eventual agreement, but we might also witness a repeat of what happened during the US negotiations with North Korea, which were also abruptly interrupted by Trump. There is now no deal in sight in that case, Kim Jon Un having reportedly started a new series of tests of tactical weapons. In the case of the trade negotiations with China, it is similarly not clear now how or when a deal could be reached. For the time being China will test whether or not President Trump is courageous enough to open a second front of his trade wars by imposing tariffs on the EU, and in partic

ular, on Germany, in the auto sector. 

According to one line of thought, this interruption in the negotiations was a result of Trump’s decision to use the window of opportunity he has to create new international tensions; a window being provided by a combination of the strong US economy, tight labour market, low inflation and buoyant equity markets thanks to the Fed’s pivot. Other analysts believe instead that it was China that misread Trump’s call for a 100bps cut to Fed funds rate, seeing it as a sign of weakness of the US economy, thereby inducing an unwarrantedly tougher Chinese stance in the final stage of the negotiations. Whatever the reason, a deal that seemed at hand fell apart last week. 

These types of miscalculations also seem to be taking place in the renewed tensions between the US and Iran. Iran has announced a partial withdrawal from the nuclear deal in response to the US decision to withdraw from the JCPOA months ago. In a typical tit-for-tat strategy reaction, the US has deployed the aircraft carrier Lincoln in the Middle East, further destabilising the region (where currency pegs to the USD have come under severe stress).  

All this is occurring while Turkey’s fragility is again becoming more prominent, the Lira having risen above 6 versus the US dollar, in spite of the central bank’s increase in policy rates from 24% to 25.5%, as international investors doubt the real firepower of the country to defend its currency in the event of a speculative attack. 

Some believe that Trump’s trademark ability is making deals, which might well be the case. Nevertheless, politics is more complicated than business, and the examples above show that the potential for geopolitical miscalculation is huge, as is the possibility of starting a conflict by accident. As historian Christopher Clark masterfully wrote, Europe “sleepwalked” its way into World War I.

These geopolitical tensions and lack of international coordination is leading to higher oil prices, which are contributing the global macro-economic environment becoming volatile and uneven, with some regions growing robustly with rising inflation, while others are weakening. To counter these developments, fiscal policy has been relaxed in the US, EU and China. Central bankers, observing this uneven scenario (which is leading to market volatility) are responding in different ways, depending on domestic circumstances. 

Within the G10 some central banks followed the Fed and turned dovish: the ECB, the BOJ, the BOC, the Riksbank, the Reserve Bank of Australiaand the Reserve Bank of New Zealand, the latter of these becoming, in the past week, the first G10 central bank to cut its policy rate during this cycle. On the other side of the spectrum there is the BOE, and above all Norges Bank, which last week increased its degree of hawkishness by pre-announcing a rate hike in June; this is likely to be indicative of an acceleration in its rate normalisation process.   

by Brunello Rosa

7 May 2019  

The decision by US President Donald Trump to present China with the threat of imposing a 25% tariff on all Chinese imported goods as of Friday 10th of May marks yet another twist in this seemingly endless saga of US-China trade relations. The decision led to immediate heavy losses in global equity markets (in Asia, Europe and the US) and shows that Trump is willing to sacrifice positive momentum in financial markets in order to pursue his “art of the deal.” Analysts believe this is just another tactical move to force the Chinese to sign a deal on less favourable terms, and that an eventual agreement will be reached in the next few weeks. Still, the move is risky for a number of reasons.

First, this episode could end up like the recent failure at the summit with North Korea in Vietnam. After proclaiming with great fanfare that a deal with North Korea was at hand, Trump ended up leaving the negotiating table, accusing Kim of unreasonable requests. It is not clear when the two sides will meet again. In the meantime, Russia’s Putin has entered the scene and complicated an already difficult negotiation process. So, breaking off discussions with China now could imply that a long pause will take place before China and the US continue negotiating. 

Second, by May 18th the US will have to decide whether or not start imposing tariffs on auto sector trade with European countries, most notably Germany. It is possible that the Chinese were delaying any agreement to see whether or not Trump would have the nerve to start a trade war on two fronts at the same time. But the effects of today’s decisions on financial markets show that the first victim of any delay in reaching a deal is China itself (and other Asian markets by extension) – and Trump knows it.  

If Trump were to open the European trade front while the Chinese front is still open, it could result in a severe hit to confidence in financial markets and economies in general. Trump has certainly shown that he is willing to sacrifice a few percentage points of equity valuations to pursue his negotiating strategies. 

Even if China and the US were to return to the negotiating table and reach a deal quickly, today’s episode shows that the relationship between the two sides remains fundamentally fraught. The strategic rivalry between China and the US on a number of dimensions (military, security, economic, investment, technology) is in full swing and will not be assuaged by any short-term trade deal. We have discussed how the trade conflict is only the most visible component of a much wider geo-strategic rivalry that amounts to a new Cold War, which we can call Cold War II.

It is quite likely that, as during the Cold War between the US and the Soviet Union, there will be a series of “truces” that will allow the two contending nations to gather their energy for subsequent returns to outright competition, instead of the two being able to reach any sort of comprehensive compromise that would more permanently end such competition. With a Cold War II, we risk returning to a two-bloc system in which de-globalization would occur, implying a massive reversal of the previous global integration in trade, investment, supply chains, technology and data transfers. This potential fragmentation of the world economy would have significant economic, financial and political implications. Like its predecessor, Cold War II is likely to be won by the richer, faster-growing, and larger economy. Only this time the winning country might not be the US.    

 by Brunello Rosa

29 April 2019  

A couple of weeks ago, we reported our impressions of the IMF meetings in Washington. The April edition of the World Economic Outlook put an official seal on the ongoing synchronised global economic slowdown, though with a hoped-for rebound in H2 this year. Within that context, some differentiations are starting to emerge. In China, the monetary, regulatory and fiscal stimulus provided by the authorities in response to the growth slowdown that occurred in H2 last year has managed to stabilise economic activity, with growth in Q1 coming out at 6.4% y/y, slightly stronger than the 6.3% anticipated by consensus expectations. As the economy shows signs of recovery, last week the PBoC offered banks USD 39.8bn of “lower profile, more targeted medium-term loans,” signalling a shift away from broad-based easing. The stabilisation of Chinese growth is among the factors underpinning the risk-on sentiment prevailing in financial markets, with equity valuation close to their historical highs. 

In the US, recent data are more of a mixed bag. Q1 GDP growth came out at 3.2% quarterly annualised, much stronger than the 2.3% that had been expected. However, this unexpected strong performance came more from net exports and a build-up in inventories, with underlying consumption remaining weak (final sales to private domestic purchasers decelerated). This week, the April Non-Farm Payroll figures (with 180K additional jobs expected, compared to 196K in March) will show whether the deceleration in economic activity will start to have an impact on the labour market. The Fed will also hold its April FOMC meeting, and the language of the statement and the press conference by Chair Jay Powell will clarify what the most recent take of the central bank is regarding the current economic and financial situation in the US. 

Japan and Europe are providing a less reassuring picture. In Japan, given the deterioration in trade and manufacturing indicators (with April industrial production falling more than the expected -4.6% y/y), Q1 growth is expected at 0% y/y. While inflation (Tokyo CPI) has recently risen to its highest rate in four years, it remains well below the 2% target, so the BOJ has re-affirmed its commitment to low rates at least until the spring of 2020, and tweaked its policy tools to signal that more easing is possible should economic conditions worsen further.  

In Europe, Q1 GDP growth (at 0.3% q/q, 1.1% y/y) is expected to remain broadly in line with Q4 2018 readings, but the economic and political landscape continues to provide worrying signals. In Germany, the March IFO business expectations sub-index declined to 95.2 from 95.6, sending the 10y bund yield back into negative territory. For the time being, talks of the possible merger between Deutsche Bank and Commerzbank have collapsed. The deceleration in economic activity and the need to invest is reportedly prompting a shift in economic thinking, with a possible relaxation of the stringent fiscal rules. In France, President Macron’s list of promised actions resulting from “Le Grand Débat National” might be read as an act of defiance by the Gilets Jaunes. In Italy, political instability and budget uncertainty are putting BTPs under renewed stress, with the 10y BTP-bund spread returning to 270bps recently. In Spain, the election has failed once again to provide a majority to support a government in parliament, where the alt-right movement Vox has entered for the first time with 24 seats. The UK remains mired in its Brexit mess. 

Given this background, all the G10 central banks apart from Norges Bank have turned dovish, following January’s pivot by the Fed. In Sweden, the Riksbank has returned towards its traditionally dovish positions. In Canada, the BOC has announced a long pause in its normalisation process. In Australia, following a collapse of inflation in March, the RBA might cut rates in May. While for now rate cuts are off the table in the US, the market-derived probability of a Fed rate-cut in 2019 has increased this week to 74%, versus 43% last week. 

In a recent study, we discussed whether the US could decouple from Europe if the EZ ended up in recession, and established that they can, so long as the EZ shock is mild. But if the shock to the EZ is large, even the US will not be able to escape it.  

by Brunello Rosa

23 April 2019  

On Sunday, Spain will go to the polls to elect a new Congreso De Los Diputados and decide 208 of the 266 seats of the Senate. As we discussed in our recent analysis, the Socialist Party (PSOE), led by incumbent Prime Minister Pedro Sanchez, is leading the polls, with support from roughly 30% of the electorate. It is ahead of the People’s Party led by the new leader Pablo Casado, which has around 20% support. Domestically, the most relevant aspect of this election is the fact that the Spanish political system, which used to be solidly bi-polar until a few years ago, has now become a 5-party system. In addition to the Socialists and the People’s Party, Podemos, Ciudadanos, and the new alt-right Vox party are the other three parties looking to win significant numbers of seats.  Even if Sanchez were to win this election, he might have a difficult time forming a government. 

In our analysis of this week’s elections we explore all the possible parliamentary coalitions that could support a government (there are a number of these as the Spanish system allows minority governments, even minority-coalition governments, to survive in parliament for the entire political term). Sanchez’ Socialists might need to form a coalition with Podemos and other regional parties in order to remain in power, which would make the government particularly fragile and exposed to opposing demands from different parties. On the other hand, while the Socialist Party might win the most seats, the People’s Party might be tempted to repeat at the national level the experiment that has been carried out in Andalusia, where a right-wing coalition was formed with Ciudadanos and Vox. In any case, political instability and fragmentation has reached the shores of Spain, and will stay there for some time yet.

At the international level, the election in Spain will be followed a few weeks later by the European elections of May 23-26. Populist parties are expected to do very well in those elections, and, if the UK takes part in them, those parties might receive a further boost from the newly-formed Brexit Party, led by Nigel Farage, the pro-Brexit leader who left politics temporarily after achieving his historical goal of setting the UK on a course to leave the EU (with the referendum in 2016). Currently, the Brexit party is leading the polls with around 27% support. Of course, the other big question mark is whether the UK will also hold a snap election ahead of the new October 31st “Halloween” Brexit deadline. 

After the European elections, Portugal will go to the polls on October 6th for a national election. Portugal’s PM Antonio Costa (leader of its Socialist Party) will try to repeat the “miracle” of 2015 when, even though his party ended up in second place, behind the Social Democratic Party, he managed to become Prime Minister by putting together what seemed initially a very unlikely coalition with the communists and the radical left. Not only did this coalition survive, it also managed to put an end to the European-imposed austerity that had fatigued the country and increased its poverty and inequality. This coalition government has also allowed the Portuguese economy to recover, and re-balance the country’s fiscal budget. For these outstanding results, former German Finance Minister Wolfgang Schaeuble said that Mario Centeno (the former Finance Minister of Costa’s government, now head of the Eurogroup) was the “Cristiano Ronaldo of the Ecofin.”

Within this European landscape, the big unknown remains Italy. Will the expected large victory by Salvini’s Lega, at the expense of Di Maio’s Five Star, lead to new elections being held in the autumn? Some press reports suggest this might be the case, but one still needs to consider that President Mattarella might be unwilling to dissolve parliament during the autumn’s budget season. At this stage, all options remain on the table.   

by Brunello Rosa

15 April 2019  

The IMF has just published its April edition of the World Economic Outlook (WEO) entitled “Growth Slowdown, Precarious Recovery”. The WEO notes that after a synchronised expansion in 2017 and the first half of 2018, the world has entered a synchronised slowdown, with all three of the world’s major markets are now facing economic headwinds. In the US, the effects of the fiscal stimulus that was approved at the end of 2017 are fading, and the fist fight between Democrats and President Trump over the budget, which led to the longest government shutdown on record earlier this year, are having a negative impact on the economy. So too are trade tensions and the tightening financial conditions deriving from the Fed’s policy normalisation. 

China meanwhile has been affected by its trade tensions with the US, as well as by what the IMF calls “regulatory tightening to rein in shadow banking.” And the Eurozone has lost momentum as two of the largest economies, Germany and Italy, have significantly slowed down. Germany’s economy, which narrowly avoided a recession in Q4, has slowed because of the impact of new emission standards on car manufacturing. Italy’s , which did in fact enter a technical recession in Q4, has slowed because of the higher sovereign spread’s impact on business investment and consumer confidence, and the impact of Germany’s slowdown. Elsewhere in the world, Japan’s economy too has been affected by global trade tensions, as well as by natural disasters, and emerging markets have been affected by capital outflows deriving from Fed tightening and USD strength.  

The current narrative from the IMF and the World Bank is that these headwinds will be transitory, and that the economic outlook will improve in H2 2019. This improvement is also expected to occur because of the important contribution of central banks, almost all of which have turned dovish since the Fed’s U-Turn in January, and because of the use of some of the fiscal space that is available in certain countries.  The mood prevailing among market participants and policy makers attending the IMF and World Bank Spring Meetings also seems to be aligned with this narrative. Nevertheless, some of the risks we have identified in our recent research are still present, putting the recovery in danger and making it “precarious”. 

First is the US trade dispute with China: while it seems that a deal is at hand, it has not been reached yet. Press reports suggest that China might be waiting to see if the US will launch another offensive on Europe over trade in the auto sector before signing anything. China knows that Trump cannot afford to open multiple fronts on trade, and so might be strategically delaying any deal to make it harder for Trump to lunch another offensive against it. 

Second, even the new USMCA trade deal has not been ratified yet, and the threat of the US unilaterally withdrawing from NAFTA still exists. 

Third, the Chinese economy is stabilising thanks to policy stimulus, but new episodes of slowing activity are always possible if this stimulus proves insufficient. In Europe, Germany’s recovery is not fully secured yet, and Italy seems on the verge of starting a new fight with Europe over the introduction of further measures of fiscal easing (such as the introduction of the flat tax) it cannot afford. In the UK, Brexit has been postponed, but lingering uncertainty continues to weigh on business investment and consumer spending. 

Thus far central banks have come to the rescue, making markets happy. There might be further room for this rally in risky asset prices to continue if the headwinds cited above dissipate over time. However investors should be aware that, if any of the risks mentioned above were to materialise, new risk-off episodes would be likely to occur in the months ahead. 

 by Brunello Rosa

8 April 2019  

Since the Fed’s sudden U-turn at the January 2019 FOMC meeting, when the institution led by Jay Powell delivered a surprisingly dovish 

statement suggesting that it could enter a prolonged pause in its tightening cycle, all of the G10 central banks have followed the Fed’s lead, modifying their policy stances and becoming more dovish. The only exception to this has been Norway’s Norges Bank.

Within the G4, the Bank of England, in coincidence the release of its February Inflation Report, mimicked the Fed by indicating its own shallower tightening cycle, with potentially longer intervals likely to take place between successive rate hikes. In any case, the BOE will have to wait for the result of Brexit negotiations before doing anything. 

The ECB even overtook the Fed in terms of dovishness, in a sense. Instead of simply indicating that there will be a longer period before it can start increasing rates, it decided to add policy stimulus by modifying its forward guidance and announcing a new round of TLTROs. This week the ECB will hold the April meeting of its Governing Council, which could shed more light on the details of its current policy stance. The decision to provide more policy stimulus moved the ECB closer to what the BOJ’s policy stance has been. The BOJ remains extremely accommodative – and there is as yet no end in sight to such a stance, so long as core-core inflation remains this low.

Moving now to the smaller central banks in Europe, the Swiss National Bank (SNB) is the one that is most closely following the ECB. It might have a hard time if more monetary stimulus is needed to counter a new downturn. The Danish National Bank shadows the ECB via the currency peg, and so far has not changed its policy stance. The Scandinavian central banks have been among the most hawkish recently. The Riksbank slotted in a rate hike in December (somehow unexpectedly), a hike which seemed to be ill-timed and is probably now regretted by the Executive Board. 

The SEK has remained weaker than it would have been in the past, but the renewed ECB accommodation might result in lower EUR/SEK, with an impact on inflation. The Riksbank has suggested that a new hike could come in H2 this year, but we see an increasing chance that this might not happen.  As mentioned above, Norges Bank is the most hawkish among G10 central banks and is the only one that has not changed its stance towards a more dovish position. It recently delivered a rate hike and, in line with our view, indicated that more tightening is coming in H2.

Moving to Oceania, in February (following the Fed) the RBA altered its policy stance and moved from a tightening bias to a neutral position, joining the RBNZ which had instead decided to stay put on that occasion. In March, the RBNZ altered its position in line with the Fed and indicated that its next move is likely to be a rate cut. In our view, this move put pressure on the RBA to also shift the balance of risks of its neutral stance to the downside. Indeed this is what happened in April, when central bank governor Philip Lowe changed a few words of the policy statement accompanying the decision to keep rate unchanged, to suggest that the RBA could be considering rate cuts much more closely than it has done so far. 

The Fed’s move has also had an impact on EM central banks. As we discussed in our recent Strategic Asset Allocation update, the more dovish stance taken by the Fed opens up policy space for shallower tightening cycles or even rate cuts by central banks that are less concerned about their currencies weakening relative to the USD. The recent decision by the Reserve Bank of India to cut its policy rate from 6.25% to 6% (the second cut in three months) is an example of this already beginning to take place.  

by Brunello Rosa

1 April 2019  

A growing number of policy and macroeconomic uncertainties are weighing on household and business confidence and, by extension, are weighing on global economic activity. Between the world’s major superpowers (US and China) there is a trade dispute that remains unresolved, and the two sides admit that it might take months before a deal that can satisfy both sides is finally struck. Meanwhile Italy is making side deals with China regarding China’s Belt and Road Initiative, a move that has infuriated its American and European partners alike. In Europe, the Brexit saga is getting more and more complicated, with Britain’s parliament having rejected for a third time the deal its prime minister negotiated with the EU. There are less than two weeks left before the UK crashes out of the EU without any formal arrangement; EU Council President Donald Tusk has called an extraordinary summit for April 10th. Theresa May is likely to try to push her deal through parliament for a fourth time before giving up. If she fails to do so, then a further extension of Article 50, snap elections, or a new referendum cannot be ruled out. 

All of this is occurring just a few months before crucial EU elections will take place, elections in which populist parties are expected to do very well an could potentially bring about a radical shift in the European policymaking. Perhaps a small sign of hope came last week, with the election of a pro-European, anti-corruption candidate, Zuzana Caputova, as president of Slovakia, breaking for the first time the unity of the fiercely anti-European Viségrad group (the group of countries that includes Poland, Hungary, Slovakia and Czechia).

In emerging markets, local elections in Turkey were held yesterday at a time of renewed tensions for the Lira. The central bank in effect increased the policy rate to 25.5% by suspending the regular 1-week repo auctions (priced at 24%), thereby forcing banks to borrow through the O/N lending facility. In Ukraine, the first round of a presidential election could result in the victory of the comedian Volodymyr Zelensky, who has almost no political experience to oversee the ongoing results of the tragic developments that have taken place in the country during the last few years.  

This is just a sampling of events currently weighing on investor and consumer confidence, as economic growth is slowing down globally and inflation is falling back below central bank targets. Where some policy space is available (and sometimes even where it is not), governments are trying to cushion economic activity with fiscal support. Equally, central banks have all turned dovish, have paused their tightening cycles, or are prepared to cut rates again if necessary, at the same time as yield curves are (chiefly in the US) becoming inverted. As we discussed in our recent analysis, the Fed might even amend its inflation targeting regime to make sure that lost inflation does not become foregone (sometimes called bygone) inflation. 

The ECB recently provided more accommodation, and, at its recent Watchers conference in Frankfurt, confirmed that it is looking at measures to protect bank profitability from rates being low for a longer period of time. The BOE again left its rates unchanged at its MPC meeting in March, knowing that the key driver of any future move will be the outcome of the Brexit process. The RBNZ has just updated its forward guidance and indicated that its next move is likely to be a cut, putting pressure on the RBA to move the balance of risks to the downside. In EMs, central banks have less pressure to defend their currencies from an appreciating dollar, given the recent dovish U-turn by the Fed. Some of them are ready to cut rates in coming months, as inflation has generally fallen within a manageable 5-10% range. 

As we discussed in our latest Strategic Asset Allocation and Market Update, risky asset prices will be supported by reduced liquidity withdrawal by central banks, even as these asset prices remain vulnerable to bouts of volatility. In such an environment, investors will likely maintain a defensive risk profile, and continue to focus on and prioritize capital preservation above other investment goals.  

Sources: NDRC, Commerce Ministry, Digital Silk Road Project, IMF, http://www.silk-road.com/artl/marcopolo.shtml  

by Brunello Rosa

25 March 2019  

China’s President Xi Jinping and Italy’s Prime Minister Giuseppe Conte were present at a ceremony in Rome on Friday, in which 29 protocols of a “non-binding” Memorandum of Understanding (MoU) were signed by several members of their two governments. The protocols cover areas including agriculture, e-commerce, satellites, beef and pork imports, media, culture, banking, natural gas, steel, science and innovation. They also set up a dialogue mechanism between the two countries’ respective finance ministers. Among the various deals signed between China and Italy were two port management agreements between China Communications Construction and the ports of Trieste (which is situated in the northern Adriatic Sea) and Genoa, which is Italy’s biggest seaport. Luigi Di Maio, Italy’s deputy prime minister, said that the value of the various deals is around EUR2.5bn, with the potential of rising to EUR 20bn over time, if and as Italy succeeds in its intention to rebalance the trade deficit it has with China by increasing Italian exports to China as well as Chinese investment in Italy.

This Memorandum of Understanding has raised more than one eyebrow in Europe and in Washington, as Italy is the first G7 country and the largest country in the EU and Eurozone to have yet signed up for China’s flagship Belt and Road Initiative (BRI). The EU has re-affirmed that China is a “strategic rival” of the EU, and the US fears that Rome might be weakening its traditional Western ties with NATO, the EU and the Eurozone. Press reports preceding Xi’s trip to Rome suggested that Italy’s top-ranking officials had discussed with their Chinese counterparts the possibility of China buying Italian sovereign debt (which is the third largest amount of sovereign debt in the world). Italy’s European partners have warned the country not to fall into a “debt trap” in which its strategic decisions would eventually be made by the owner of its sovereign debt rather than decided upon by the Italian government.

The reason for China to sign such a deal is obvious: Xi will be able to show, both domestically and to his strategic rivals (particularly the US), that he managed to bring a large G7, NATO and EU member country to China’s side in the BRI, which is regarded as the most important Chinese geostrategic initiative. The level of commercial commitment China is making with this deal is minimal (as its effects will only be produced over a long period of time), while the political prize of the deal (prestige, which is being realized immediately) is huge. When Xi will get to Paris this week, the tune will be different. France, Germany and Brussels are worried about China scooping up strategic European assets, so they are likely to impose restrictions – albeit less draconian than the US ones – to Chinese takeovers of strategic European assets. France and Germany are also trying to build European champions to avoid US and China dominate key industries.

Now, why would Italy sign such a memorandum? There are several explanations. First, historically the starting point of the Silk Road (or its terminus, depending on which direction you were travelling) was Venice, the city from which the explorer and merchant Marco Polo departed to discover China, in what President Xi labelled as the first contact between China and Western civilisation. So, one cannot be surprised if China views Trieste’s port (near Venice) as the end of a modern “sea road”. Trieste is strategically important for China because it offers a connection from the Mediterranean to landlocked countries such as Austria, Hungary, the Czech Republic, Slovakia and Serbia, all of which are markets China hopes to reach through its BRI. 

Secondly, Italy has been known for decades for its ability to have friendly relationships with strategic rivals: the USA and the Soviet Union, Iran and Iraq, Israel and the Palestinians, etc. (This is a reason why often Italian troops are used in peace-keeping operations by the United Nations). Italy could very much remain a loyal member of the Western alliance while also doing business and even signing deals of this kind with China. (Indeed, the US itself, while remaining the cornerstone of the Western alliance, is seeking to sign an MoU with China to end the ongoing trade war. And the largest holder of US sovereign debt is China). Third, a stagnating economy like Italy needs to show it is “open for business” if it wants to attract foreign investment, including from China. 

Yet there are also risks involved in signing this deal. Foremost of these would be China gaining a level of geo-strategic influence in Europe much greater than the acquisition of Greece’s port of Piraeus allowed it at the end of the Greek economic crisis in 2015. Another risk is that, with Italy already taking an ambiguous stance vis-à-vis its position versus the EU and Russia, Italy risks not being considered a loyal partner to Europe, and instead is perceived to be, in effect, “up for sale” to the  highest bidder, no matter who that might be. 

Third, this entire story shows – once again – how weak the European construction is when it is comes to defending common European interests. In a world that is increasingly becoming bi-polar, wherein countries have to pledge their alliance to either the US or China, the EU could play a vital role in presenting itself as a global actor pushing for peace, prosperity, the welfare state, democracy and environmental protection. Yet when EU countries do not work together, they have little leverage to advance even their own positions. Unless the EU completes its transition towards becoming a cohesive political entity, it will not be able to play a positive global role in coming years.   Sources: NDRC, Commerce Ministry, Digital Silk Road Project, IMF, http://www.silk-road.com/artl/marcopolo.shtml  

by Brunello Rosa

18 March 2019  

With US-China trade negotiations being granted a deadline extension by President Trump on March 1st, it seems that an agreement between China and the US on their long-lasting trade disputes could finally be at hand. What might the elements of the deal include? In brief, the deal could include a commitment by China to increase its import from the US, while the US is granted increased access to the Chinese market, more protection for its intellectual property, reduced technology transfer via obligatory joint ventures, and other similar guarantees. If we only focus on the quantitative aspects of such an agreement, we could brutally summarise it as follows: China would commit to buy more stuff from the US and the US will be able to sell more stuff to China. (That is, after all, the way to reduce the US’ trade deficit with China, which recently reached an all-time high). 

Now, would this be a good deal for the world economy? On the one hand, reduced trade tensions would mean less volatility in markets, which could be beneficial for developed economies and emerging markets (EMs) both. Less protectionism would also imply a reduced drag on global growth, which in turn might also imply higher prices for certain commodities, another factor that could be beneficial for commodity-exporting Ems. (Moreover, so long as commodity prices do not increase too much, this would not necessarily impact DMs too negatively). As part of the trade deal China might also commit to stabilizing its trade-weighted exchange rate and allowing more transparency regarding its reserves and reserve policy. Trade-weighted currency stabilization would be better for Europe than China pegging to the US dollar alone, which tends to hurt the Eurozone at times when the dollar is weak.

On the other hand, not all that shines is gold. Even if a temporary agreement were to be agreed on between China and the US, the cold war between the two global geopolitical superpowers will continue. The sub-components of this wider rivalry, such as the technological competition between them and the balkanisation of the global supply chains, will also continue, and, as the recent row around Italy’s memorandum with China on the Belt and Road Initiative may show, other countries and regions will be forced to choose sides between either the US or China.  

In addition, there might be direct losers from a US-China deal of this sort. If China commits to buying more goods from the US, other countries’ exports to China might suffer, especially countries or regions which have economies that are export-led, such as Japan and the Eurozone. If China also commits to buying more US goods such as soybeans, fossil fuels, and other commodities, exporting EMs may suffer as well. Thirdly, as we discussed in a recent column, if the US and China come to an agreement , Trump will then be able to devote his full attention to an attack on Germany and its car industry (another popular bipartisan subject in the US), threatening to slap tariffs on US car imports in order to strongarm the Germans into taking a deal that is advantageous to the US.

As we discussed in recent reports, both Japan and Europe are now undergoing a severe economic slowdown, which is having important political repercussions. Germany’s slowdown means that other countries in its supply chain, such as Italy, are already in a recession. EMs are stabilising after a difficult 2018 thanks to the Fed’s more dovish stance. If those economies were to suffer again, possibly falling into a recession, the world economy as a whole would be affected, being then able to rely only on the US and China, both of which are also slowing down economically. 

Germany could seize the opportunity to rethink its business model and become less dependent on foreign demand. But that would mean revitalising its domestic demand and promoting the transformation of the EU and the Eurozone into full-fledged transfer unions (perhaps organised in concentric circles), with a vibrant internal market like the US. However, as we discussed in our recent Europe Update this seems very unlikely to happen in the near future. This will leave Europe, Japan, EMs and the world vulnerable to the volatile mood of the US president.

by Brunello Rosa

11 March 2019  

This will be one of the most crucial weeks yet in the entire Brexit process: On Tuesday March 12th there will be a second “meaningful” vote on Theresa May’s deal. The aim of the government is to present a revised version of the deal, on which the UK and EU have worked over the weekend. The UK is seeking legally binding reassurances that the backstop solution for Northern Ireland will be temporary. The EU has made it clear that it cannot re-open negotiations for the withdrawal treaty, yet seems willing to compromise. If the vote is in favour of May’s deal, the UK will leave the EU on March 29th as planned, but am “implementation” period lasting until December 2020 will ensure a smooth transition and allow the UK to reach a final arrangement with the EU. Theresa May is pledging resources for the constituencies in which current Labour MPs might be willing to vote in favour of her deal. As discussed in our recent update, if Labour decides to allow some defectors within its own party to vote in favour of May’s deal, this strategy could pay off.

If the result of this vote goes against the deal like the previous vote did, yet another vote will take place on Wednesday March 13, as the UK parliament will have to decide whether or not it is in favour of exiting the EU with no deal whatsoever. We expect the UK parliament to reject the possibility of the no-deal Brexit that the hardline Brexiteers want. There does not seem to be a majority in favour of it. On the same day, the UK Chancellor of the Exchequer will make its Spring Statement (i.e. a budget update), where revised growth and inflation forecasts will determine whether the UK’s fiscal trajectory is still in line with the October budget.  Chancellor Philip Hammond will reiterate that the UK has plenty of fiscal resources to counter a potential no-deal scenario and cushion the economy against a possible crash. If for any reason the UK were to crash out of the EU without a deal, the figures of the Spring Statement update would quickly be thrown out of the window and a fresh, emergency budget would need to be passed. 

On Thursday March 14th, the UK parliament will vote to authorise a possible extension of Article 50, which would be the logical course of action in the event that its elected officials vote to reject May’s deal on Tuesday and then vote against a no-deal Brexit on Wednesday. The EU is ready to provide a short (2 or 3 month) extension, but wants to be sure that the UK parliament will spend that time trying to converge towards a definite solution, so this cannot be taken for granted at this stage. The UK might also be blackmailed by all other European countries into conceding their vote in favour of the extension (which needs to be voted unanimously for by the remaining 27 EU countries). So, even if parliament authorised the government to ask the EU for an extension, such a request would be unlikely to be sent to Brussels until the very last minute, in order for the UK not to end up in such an uncomfortable position.

What this suggests is that this week might not be the truly definitive week in which to decide the fate of Brexit, crucial though these votes may be. As discussed in our recent Europe Update, it is still  uncertain whether or not May will manage to pass her revised deal through parliament, but even if we were to assume that her deal is rejected, and that parliament then votes against a “no deal” Brexit and in favour of seeking to extend Article 50, it would still be quite possible that the final word on this issue will only come at the very last minute, before the real deadline on March 28-29. This sort of final-hour decision has happened in a number of EU negotiations during the past few years. 

by Brunello Rosa

4 March 2019  

During the 1990s, the tendency by the US Federal Reserve to backstop the stock market was named “Greenspan’s put”, after the then-chairman Alan Greenspan. This was named for the option strategy by which the buyer of a “protective put” has the right to sell the underlying asset at a pre-determined “strike” price. If equity prices fell more than 20%, the Fed led by Greenspan would cut rates to allow equity prices to bounce back (since equity valuations would be inflated by a lower discount rate). This happened on occasions such as the “Savings and Loans” crisis in 1986, the stock market crash in 1987, the Asian financial crisis in 1997, and the dot-com bubble bursting in 2000. 

When Ben Bernanke succeeded Greenspan in 2006, he inherited this put (which duly became the “Bernanke’s put”). This was proved by the decision to slash Fed funds rates to zero during the global financial crisis of 2008 following the collapse of the US housing market and sub-prime mortgages. But in December 2015 the Fed timidly started to normalise its policy rates, bringing them to 2.50% by the end of last year. As we discussed in our review of the FOMC meeting held then, the market was very upset by the Fed’s decision to increase its target range by 25bps to 2.25%-2.50%. That action was accompanied by a press conference by Fed Chairman Jay Powell that was considered too hawkish, in spite of the reduction in expected additional rates increases signalled by the “Dot Plot”. As a result, equity markets collapsed at the end of last year. In January this year, the unexpected U-turn by the Fed, which wiped out any indication of further monetary tightening, marked the return of the Fed’s “put”, according to some market commentators. 

In our recent analysis by Alessandro Magnoli Bocchi, we discuss why we do not believe the FOMC’s U-turn marks the arrival of “Powell’s put” on the market, but rather the implementation of a “collar” strategy, aimed at supporting the market to the downside while limiting the upside. A collar option strategy, which provides a pay-off at expiration like the one depicted in the picture above, is obtained by financing the purchase of a traditional (protective) put option by selling a call option with a higher strike price. This way, if the price of the underlying asset (say, the S&P 500 index) falls below the level of the put’s strike price, the buyer of the put option is protected (its protection getting larger as the size of the stock market’s fall increases). If instead the stock market index rises above the strike price of the sold call option, the upside is limited as the seller of the option will have to pay the difference between the strike price and the level of the stock market index. 

In fact, we expect the Fed to protect the downside, as it did in January, but not unconditionally and not to the point of inflating a stock market rally that could reignite inflation and financial stability fears. If core inflation were to again rise above 2% (for example as a result of higher wages deriving from the current tight labour market) the Fed would not hesitate in raising rates again, thus likely limiting the possibility of further rapid increases in stock market prices. Thus, in our view the Fed is more likely to introduce pauses in its tightening cycles rather than cutting rates. We re-affirm our view that 2019 will be a transition year characterised by looser monetary (and fiscal) policy, endogenously responding to the macroeconomic slowdown and weakness in risky asset prices. 

The Fed is not alone in taking this approach. The ECB as well is likely to shift towards a more accommodative approach when the Governing Council meets this week, while the Bank of Canada and the Reserve Bank of Australia too are likely to remain on hold this week. 

by Brunello Rosa

25 February 2019  

Two crucial deadlines were looming this week: US-China trade talks on March 1st and the second meaningful vote on Brexit on February 28th. 

Regarding US-China trade talks, Donald Trump said the US could extend the negotiations (perhaps by 30 or 60 days) from the March 1st deadline and meet with President Xi Jinping at Mar-a-Lago after the National People’s Congress on March 5th, given the progress made. 

Negotiators are preparing six Memorandums of Understanding (MoUs) on key structural issues such as: forced technology transfer and cyber theft; intellectual property rights; services; currency manipulation; agriculture; and non-tariff trade barriers. 

Later, in April, the Department of the Treasury will issue its semiannual report to Congress of its reviews of developments in international economic and exchange rate policies across the United States’ major trading partners. In its latest issue of October 2018, the US refrained from labelling China as a “currency manipulator” (as it did between 1992 and 1994), while reiterating that China’s foreign-exchange practices deserved close monitoring, especially in light of the recent weakening of the renminbi. If sufficient progress is not made in the US-China trade talks, it is likely that the US will start branding China as a currency manipulator again, thereby justifying a series of retaliatory actions. Interestingly, also in the list of countries deserving close monitoring is Germany (for its large current account surplus), confirming that Germany might be the target for the US’ next round of trade wars (as discussed in last week’s column).

Regarding Brexit, Theresa May announced on Sunday that a second meaningful vote by parliament will be held on March 12th, instead of February 28th; in other words, just a couple of weeks before the official Brexit deadline on March 29th. Scheduling the second vote so close to the deadline is clearly intended to put pressure on MPs to accept Theresa May’s revised deal, or else face a no-deal Brexit. MPs are getting increasingly nervous from this approach by the PM and are openly rebelling against it, with three cabinet ministers threatening to vote against a proposal that allows a no-deal Brexit to occur. Meanwhile, a new Independent Group of MPs was  created in the House of Commons, formed by nine former Labour party members and three Tories. This group is already larger than the delegation of Lib-Dems and of the DUP (which props up May’s majority) in the Commons and might end up holding the balance of power in the final vote, especially if it grows further.

Theresa May is convinced that, in the end, a last-minute deal relaxing the terms of the Irish backstop (either with a time limit, or with the possibility of unilateral withdrawal, or with an additional legal document making clear that the UK would not be kept permanently in the arrangement) will be made with the EU. In Brussels, the sentiment is less sanguine. We believe an agreement will eventually be found – perhaps after an extension of Article 50 by three months, but the risk of a “Br-accident” is increasing. 

This protracted uncertainty regarding key issues, together with the global economic slowdown, is weighing on investor sentiment and pushing an increasing number of central banks to dilute their normalization plans. After the Fed, the ECB, and other major central banks, the RBA has also now dropped its hiking bias and has a neutral stance, joining the RBNZ in such a position. Among G10 economies, the only central bank that still has not made any move is the Swiss National Bank, which risks having to fight increasing domestic and international risks with little policy ammunition.  

by Brunello Rosa

18 February 2019  

On March 1th, the truce between US and China that was agreed to regarding their bilateral trade war will officially end, as will the time available to reach an agreement to avoid increasing tariffs from 10% to 25% on USD200bn of Chinese exports to the US. Officials from both sides seem to suggest that a deal might be in sight, nevertheless a number of issues will remain open. Most important of these is that any agreement will be temporary, as the underlying cold war between the US and China will continue to be waged on different battlefields, as we have discussed in previous columns and research papers. In particular, the two countries will continue to compete intensely over technology (as the ongoing Huawei case proves). 

In addition, the implementation of any plan to reduce the bilateral trade imbalance between China and the US will not be frictionless. Regardless of whether China agrees to import more from the US, or export less to the US, there might be severe consequences on global trade flows, technological transfers, CNY and USD valuations, the level of Chinese reserves of US Treasuries, long-term US Treasury yields and, ultimately, global price and financial stability. The optimal strategy of pursuing global free trade with flexible exchange rates on a multilateral basis (for example by continuing to push China towards greater openness of its capital account) does not seem at hand in an increasingly protectionist world dominated by strongmen.   

However, let us assume for the time being that some sort of deal between US and China is achieved by March 1st. Will this mean peace at last in the global economy? 

To the contrary, it will probably mean that, with one front temporarily closed, Trump will instead start devoting its full attention to another “trade war” close to his heart: the international auto sector, the most notable victims of which would be European and Asian producers, were the US to raise tariffs. In fact, President Trump will soon receive a report from the US Department of Commerce addressing his question of whether imports of cars pose a threat to national security. It is not yet known what the report, expected to be sent by February 17th, will recommend the president to do, but it is very likely that it will offer a range of options, including imposing quotas or voluntary export restrictions, or tariffs. The one thing that Trump managed to obtain with the transformation of NAFTA into USMCA is less favourable conditions for producers to export cars to the US. He is likely to want to adopt a similar stance towards other car producers, particularly German ones. 

In fact, it is almost certain that among the biggest losers of the upcoming round of trade wars will be Germany, the economy of which – as we discuss in our recent trip report – is already suffering from a deteriorated external environment. The slowdown in Germany is affecting the entire Eurozone economy, with the more fragile countries, such as Italy, having already entered a recession. At the Munich Security Conference just concluded, the US and Germany have further exposed the fact that they have opposing views regarding global security, as expressed by Chancellor Merkel and Vice-President Pence. We would not be surprised if a US trade war with Germany over the auto sector become just another example of geopolitical diplomacy, fought with different weapons.   

Picture from the “Populism Research Group” at Loughborough University 

by Brunello Rosa

11 February 2019

Eduardo Bolsonaro, one of the sons of Brazil’s newly elected president Jair Bolsonaro, was chosen as the head of “The Movement” in Latin America last week. “The Movement” is the organisation created by Steve Bannon, former advisor to US President Donald Trump and Chief Strategist at the White House, to coordinate the activities of populist groups and political parties around the world. It is expected to be launched with an event in Brussels in March. 

In effect, “The Movement” aims at creating a unifying ideology for the various populist experiments around the world, connecting groups which thus far have been mostly disconnected from one another (in part, because they tend to have a nationalistic bias, which has made it harder for them to be “internationalists” working together to promote similar goals). Their manifesto is clear: “We stand together in our pursuit of a populist nationalist agenda for prosperity and sovereignty for citizens throughout the world.”

The creation of “The Movement” and its official expansion in Latin America marks the formal launch of what we have called, in our previous columns and recent analysis, the Populist International. Its motto could be “Populists of the World, Unite!” There is no hidden agenda here: the Populist International aims to “reclaim sovereignty from progressive globalist elitist forces and expand common sense nationalism,” against the “globalist world order,” with “governments re-asserting their sovereignty…against the dangerous [United Nations’] Global Pact on Migration.”      

What could the implications for the world be if the Populist International were to become established and eventually succeed in implementing its agenda? In our recent analysis, we discussed how, in Europe, this could mean that the process of dis-integration, which is ongoing and is accelerating with Brexit, could continue and eventually lead to a continent that, instead of being orderly organised in concentric circles, might re-group itself into clusters, with the strongest of these being one formed around Germany and its core allies. Such an outcome would have massive macroeconomic and financial implications, which we describe in detail. In Latin America, a success of the initiatives promoted by “The Movement” would likely accelerate the ongoing shift of political systems from populist regimes of the left to authoritarian regimes of the right (discussed in our column last week). This might have implications for commodity price, including oil, considering that Latin American countries are among the major commodity exporters (and China among the key importers). 

At the global level, the success of populist/nationalist policies would likely favour the rise or further strengthening of “strongmen”, who are already populating the world scene. The first victim of strongmen tends to be the independence of regulatory bodies and central banks. Sometimes markets like strongmen, but markets also tend to stigmatise and punish those regimes in which central bank independence is, or appears to be, compromised. Typically markets do this by selling off such countries’ currencies (Turkey being the most notable recent example). In addition, the autarkic solutions, generally favoured by strongman at national level, are not compatible with each other at the international level, and this tends to create geopolitical tensions, which eventually weigh on market sentiment.

by Brunello Rosa

4 February 2019  

Recent events in Venezuela show that the world’s geopolitical tectonic plates continue to move. Whether or not Juan Guaidó succeeds in becoming the country’s next president (and if so, whether that will happen peacefully or only after another bloodbath) is yet to be determined. Clearly the missing link in Guaidó s puzzle is the support of the army: if he were to receive that, his ascension to power would soon be completed, with or without another election being held. But the fact that all of the world’s major powers took a position on the Venezuelan saga suggests that something is going on there that is much deeper than a typical power struggle inside of a medium-sized Latin American country.

Guaidó could not have made the bold move he did without receiving the direct or indirect support of the US, which was in fact the first country to recognize him as president (followed shortly by the UK and Canada; several major European countries are threatening to do the same, unless Maduro calls new presidential elections). Taking the opposite position, Russia, China, and Turkey stood by Maduro. John Bolton, President Trump’s National Security Adviser, said that US oil companies are ready to invest in Venezuela, which has the largest oil reserves in the world. Still, this political saga is not only about oil. 

The world’s geopolitical order is changing. Trump’s decision to leave Syria (against the advice of his former Defence Secretary James Mattis), in conjunction with his decision to back Guaidó in Venezuela, could be viewed as a move to re-pivot US attention to Latin America, after many years of neglecting the region. As we discussed in previous columns, a number of Latin American countries seem ready to rapidly switch from populist or authoritarian regimes of the left (with Chavez and Maduro being primary examples) to populist or authoritarian regimes of the right (with Brazil’s Bolsonaro being the primary example). Political shifts of this kind have already occurred in Brazil and Colombia. Venezuela seems ripe for a similar transition, and other countries in the region, such as Argentina, might follow suit.   

If the US refocuses on Latin America, which it has considered to be its backyard since US President Monroe, other global powers seem quite unlikely to be able to counter this shift. Russia has recently made it clear that Venezuela will not be another Syria. China for the time being is mostly using only its economic position to exert influence in Latin America, for example by being among the major importers of the region’s natural resources. China however is also focusing its attention on the Belt and Road Initiative (BRI), which will imply a massive influence in Asian and African countries. As Parag Khanna discusses in his recent book, the major geopolitical arena of this century will be Afro-Eurasia, given the influence that China and India will have on a number of African countries. 

So far, the response of the US after Obama (who tried his own pivot to Asia)  has been inward looking: pull out of the Middle East, weaken NATO and the EU, re-focus on Latin America and attempt to build a wall along the border with Mexico. However, this tactical response might prove insufficient, unless the US wants to give up its global supremacy sooner than it otherwise would. The US might soon re-discover the importance of the Western alliance with Europe, the importance of maintaining influence in the Middle East, the importance of making sure that China does not promote regime changes in Africa and excessively influence regions like Latin America economically. Accomplishing these goals would likely require a new political leadership in the US, with a different view of the world. 

by Brunello Rosa

28 January 2019  

The 2019 annual meeting of the World Economic Forum highlighted a number of themes and risks, most of them related to the effects of climate change on the global environment and its repercussions for human conditions and economic activity. Participants highlighted rising political and geopolitical risks (as exemplified by the recent leadership challenge in Venezuela,

which is polarising the positions of the most influential nations in the world), as well as the possibility of a bursting bubble in risky asset prices. 

Overall, the sentiment of market participants and policy makers was quite subdued, in spite of the underlying optimism encouraged by the prospects of the Fourth Industrial Revolution (a theme launched by the Forum’s founder, Klaus Schwab). Nouriel Roubini presented R&R’s views on the possibility of a new global financial crisis and recession taking place in 2020 and found a very attentive audience, much less sceptical than it was in 2006 when he predicted the Global Financial Crisis of 2008. Having said that, sentiment in the Forum has been in the past a contrarian indicator of eventual outcomes, as participants might tend to have adaptive, rather than forward-looking expectations. 

Within the context of a weakening global economic expansion, the endogenous policy response we expected to take place is materialising. Last week the Bank of Japan left its policy stance unchanged but downwardly revised its inflation projections, suggesting that it might remain on autopilot even beyond spring this year. The ECB, meanwhile, downgraded its risk distribution around the growth projections from “balanced” to “negative”, suggesting that it might take longer before starting to normalise rates, and that new forms of monetary stimulus (such as a new round of (T)LTROs) might be adopted quite soon. 

In its first January press conference this week, we expect the Fed to signal (without pre-committing) the possibility that a pause in the tightening cycle might take place as early as March. Conversely, confirming its hawkish bias, Norges Bank left its policy stance unchanged but confirmed that a new rate increase might still occur in March.   

Financial markets are buffeted by worries about the weakening global economy, rising geopolitical risks, and the endogenous policy response that these risks are generating. For the time being, they are still recovering the losses made in the last few weeks of 2018, but have not yet completed that process. As we said in previous columns, 2019 will be all about this tug of war between bad macro and geopolitical news on the one hand and policy responses on the other. By 2020 it should be clearer which of the two sides has prevailed. 

Certainly, a risk that is worth monitoring is the solidity of the global financial system, of which banks are a crucial component. In 2008, the fragile global banking system was the propagator of the financial crisis, triggered by the small sub-prime mortgage market. In 2019, banks are generally better capitalised, with sounder business models, and with higher levels of liquidity to face sudden market reversals. However, as some notable examples have shown in recent months, banks nevertheless remain exposed to all sorts of risks: market, credit (with particular reference to the leveraged loan market), reputational, legal, business. In our recent report on the future of banking, we discuss all these risks and suggest the market implications of these developments.

It is not yet known whether a new global financial crisis is coming. Certainly, if banks will once again be part of the problem instead of the solution, such a crisis is likely to be much worse than it would be otherwise. We hope this is not going to be the case. 

by Brunello Rosa

21 January 2019  

The global economy continues to decelerate. As a result of its longest ever government shutdown, US growth is likely to suffer in the coming months. (US PMI’s are expected to show this starting this week). The glimmers of hope coming from US-China trade talks, with China offering to increase its imports from the US to USD 1tn in the next six years (from 190bn in 2018), might not be enough to stop this deceleration, in the absence of fiscal and monetary stimulus. In China, Q4 GDP figures this week are expected to confirm a deceleration from 6.5% to 6.4% y-o-y, led by a contraction in exports. In the Eurozone, Germany’s preliminary GDP growth figures showed a deceleration to 1.5% in 2018 (down from 2.2% in 2017), after its GDP contracted in Q3. 

According to Banca d’Italia, Italy seems destined for a technical recession, its GDP having contracted in Q4 2018 after also doing so in Q3. The central bank has updated its forecast for Italy’s GDP growth in 2019 to 0.6%, a pace of growth that is only about half of the most recent 1% growth forecasted by the country’s government (a forecast that does not even rule out the possibility of a supplementary budget during the year, in order to realign Italy’s fiscal deficit to the level agreed upon with the EU). 

Given these decelerating conditions, and considering that inflation remains easily in check, short-term policy responses are underway. Last week, the PBoC injected a net CNY 560bn (USD 83bn) into its banking system, the highest amount ever recorded in a single day. Next week, the Fed is likely to provide further hints about a pause in its tightening cycle. This week, the ECB should acknowledge the ongoing economic deceleration and suggest continued or increased gradualism regarding its exit from the extraordinary accommodation it has provided in the last five years. 

Also this week, we expect the BoJ not to take any meaningful action while downwardly revising its growth and inflation outlook. We also expect Norges Bank not to move this week while confirming its forward guidance for a hike to take place in March. In the UK, on Monday the government will present its Plan B for Brexit, but no vote is expected until next week. The BoE remains ready for any eventuality. Considering these moves, markets are having a bit of respite: risky asset prices are slowly recovering the losses they experienced at the end of last year.   

Underlying these short-term wobbles are much deeper economic challenges. In our recent in-depth report on demographics, we discuss how current demographic trends tend to impact economic and political developments, policy choices and market outcomes more profoundly than short-term policy (monetary, fiscal, regulatory) fixes. In our global overview, we look at demographic developments in the US, Latin America, Europe and Asia, finding that most of the policy choices we see being made today are already partly the result of underlying trends that have been in place for decades. The coming generation of policymakers will be bounded and constrained by these persistent trends. The moral of the story here is quite simple. While managing short-term macroeconomic developments, policy makers should also address long-term issues. Otherwise, the challenges these long-term issues pose will eventually become insurmountable by conventional instruments. 

by Brunello Rosa

14 January 2019  

As we discuss in greater detail on page two of this ViewsLetter (below – for the website), clouds are starting to gather for the global economy. In the US, the stalemate in Congress regarding the budget, in particular the controversial USD 5bn financing for the wall at the border between US and Mexico, has caused a government shutdown that is now entering its fourth week, becoming the longest in US history. Apart from the obvious collapse in the provision of services (in airports, national parks, museums and other publicly-managed organisations), the pain is starting to be felt by 420,000 government employees, whose payslip are showing “zero salaries” for most of them. All this will eventually have a macroeconomic impact, when the figures for Q4 2018 and Q1 2019 growth will be released in coming months.

In Europe, the situation is not much rosier: industrial production in the largest Eurozone economies (Germany, France, Italy) has collapsed recently, partly as a result of the difficulties of German car manufacturers to adapt to new emission standards. In France, the protest of the Yellow Vest continues to be intense, and is putting pressure on President Macron. In Italy, after the contraction recorded in Q3, there is a serious risk that Q4 2018 GDP growth will also witness a negative growth figure. That would mark the beginning of a technical recession in Italy (so much for the supposedly expansionary policies of the new populist government). In the UK, it is almost certain that Theresa May’s deal with the EU will be voted down by parliament, marking the beginning of a political crisis that will be protracted for weeks, and will likely have severe economic repercussions. 

In Emerging Markets, the situation remains problematic: China is undergoing an economic slowdown resulting from the trade tensions of 2018 have yet to be reversed, in spite of the expansionary (fiscal, monetary and credit policies) adopted by the authorities. Glimmers of hope derive from the unexpected extension of trade talks with the US, but make no mistake – whatever deal can be agreed on will only be partial and temporary; the cold war between the US and China is set to continue for decades. In Brazil, Bolsonaro’s government has yet to show its true colours, but the market is giving it the benefit of the doubt. Regarding Turkey, our latest scenario analysis discusses the evolution of the country over the next few years. We do not expect a real stabilisation to begin before the local elections there in March.

Given this background, it is not a surprise that the World Bank (whose president’s impending departure in February has opened a complicated transition phase) has revised lower its global growth forecasts. How are policymakers and financial markets reacting to all this? 

As one might expect, an endogenous policy response has already begun. The Fed has signalled that it can be more patient in policy tightening cycle, making a pause in March more likely. The Bank of Canada has kept its policy rate on hold in January, as it did in December. The ECB and BOJ are currently on autopilot, and the BOE is ready to react to Brexit developments in any way that may be needed, so its tightening cycle is on pause until May at the earliest. With central banks more cautious regarding the withdrawal of liquidity, risky asset prices could take a breath: equity prices are slowly recovering the losses they suffered in the final few weeks of December. This is what 2019 will be: a transition year between the 2017-18 expansion and a possible crisis and recession in 2020. Financial markets will be cushioned from the effects of bad economic and geopolitical news by the endogenous policy response.

by Brunello Rosa

7 January 2019  

After the holiday break, activity resumes in full swing this week. An appetizer came last Friday, with the release of the Non-Farm Payroll (NFP) and related data. The US economy showed signs of continued strength with the labour market adding 312k jobs (versus 177k expected) and the unemployment rate ticking up to 3.9% (versus an expected 3.7%, unchanged from the previous month), pushed by higher labour force participation (at 63.1%, versus 62.9% previously). On the inflation front, average hourly earnings also rose to 3.2% y-o-y (more than the expected decline to 3.0% from the previous 3.1% reading); this week’s data on CPI will clarify whether the tightness of the labour market will be able to translate into higher headline and core inflation. 

Also this week, the minutes of the FOMC meeting in December will shed further light on the Fed’s thinking concerning its 25bps rate increase in the Fed funds target range, to 2.25%-2.50%. The policy stance of the Fed in the first few months of the year will be a key driver of market sentiment. While the market-implied probability of there being no Fed hikes in 2019 has increased to 90% (versus 64% last week), currently the Fed is strictly data dependent and unlikely to commit to any specific policy action in coming weeks. The Fed has three instruments at its disposal: rate policy, Quantitative Tightening (QT, i.e. the reduction of its balance sheet) and forward guidance via the “dot plot.” We believe that the bar for altering the pace of QT, which is pre-set and mostly dictated by technical factors, is quite high. The Fed might opt for a combination of rate policy, forward guidance and communication (including its press conferences at every meeting) to steer market sentiment. 

Equally important for market participants will be the resumption of trade talks between China and the US,  following the truce agreed to on the sidelines of the G20 meeting in Buenos Aires at the end of November.  We continue to believe that trade tensions are only the visible skirmishes in a much deeper, geopolitically-motivated technological competition between the rising power of China and the incumbent American superpower; a competition that is rapidly becoming a new Cold War. 

On Wednesday, the Bank of Canada will also meet for its policy meeting and the release of its latest Monetary Policy Report. Until a few months ago, January was considered the chosen month for an additional 25bps increase to a rate of 2.0%, but the situation has changed in the last few weeks, with the collapse in oil prices and the correction in risky asset prices that has affected most developed markets, including in North America. Market consensus is now expecting no interest rate change to occur.

Another central bank at the centre of investor attention this week will be the ECB, which will release the accounts of its December monetary policy meeting. Market participants will look for further clarification on the ECB's re-investment policy, following the end of its bond-buying program. 

So, this week market participants will again have their plates full with news to digest. All this activity will mark the beginning of another challenging year, one that could possibly lead to another global economic slowdown and financial crisis occurring in 2020.   In this respect, while investors exited equity funds amid the correction in risky asset prices at the end of last year, gold prices started to rise again, together with inflows into gold-backed ETFs. 

by Brunello Rosa

2 January 2019  

At the end of the year, we published our Global Outlook and Strategic Asset Allocation for 2019. In it, we discussed how in 2019 the global economy is likely to enter a slowdown phase, the result of a deceleration of growth in the US, China and the Eurozone, and EM economies remaining fragile. This deceleration will involve a number of large economies returning towards (or even below) their trend growth levels, a reversal of the acceleration they experienced in H2 2017 and H1 2018, the latter as a result of the US fiscal impulse. While output gaps continue to close, core inflation still finds it difficult to reach and remain consistently at levels that are compatible with central banks’ inflation targets. This is a result of the persistent flatness of the Phillips curve in a number of countries, especially developed economies. 

As core inflation remains subdued, the world’s major central banks (Fed, ECB, BOE, BOJ) can be more cautious in their approach to monetary policy normalisation. A number of EM central banks will have to continue to strike a difficult balance between defending their currencies and supporting economic activity. At the same time, fiscal policy is likely to remain globally neutral, with the US fiscal impact expected to fade away towards the end of 2019.

From a geopolitical perspective, John Hulsman made his top predictions for 2019, which can be summarised as follows: 1) While there will be a Sino-American deal that will temporarily limit the trade war, the bigger story is an approaching cold war between the world’s two most important powers. This will be a decades-long strategic conflict that the US is likely to win (though such a triumph is far from being an inevitable outcome). 

2) With Macron politically damaged following the yellow vest protests, the European establishment’s hopes for desperately needed reform have come to nothing. The continent’s terminal decline will become apparent in 2019.  3) Contrary to the fantasies of much of the commentariat, President Trump will not be removed from office. But the Democrats in the House will torment him with endless investigations, and almost nothing will get done in America domestically with the exception of two Fed rate hikes. 4) The process of Emerging Market differentiation will continue in 2019, as investors increasingly come to evaluate developing countries on their own terms rather than considering them as part of a homogeneous group. 

So, while overall the global economy is still in a growing, albeit decelerating, phase, clouds are gathering on the horizon. Risky asset prices have recently shown signs of fragility, to say the least, reflecting ongoing risks (rising geopolitical tensions – including in the Balkans, worries about Fed policy, trade wars, balkanisation of global supply chains) and the potential for a deceleration in economic activity. In most markets, especially in Europe, bank shares have underperformed general indices, a result of the impact of regulation, rising short-term rates, low long-term rates and the negative feedback loop between fragile sovereign bonds and their balance sheets. Financial institutions could again be the canary in the coal mine of the next financial crisis. 

In this environment, investor are likely to continue de-risking by adopting a defensive approach and reducing exposure to assets with stretched valuations (credit products, leveraged loans, some real estate), without completely abandoning risky assets.

by Brunello Rosa

24 December 2018  

In our column on March 26th, entitled Who Checks on “The Boss” in Washington, we discussed the possible implications of a series of resignations by key respected figures of the Trump’s Administration,  among them  the Director of the National Economic Council (NEC) Gary Cohn, Secretary of State Rex Tillerson, and National Security Advisor H.R. McMaster. At that time, we highlighted how the team of experts that was advising the president on strategic economic and geopolitical matters (and to a certain extent was even managing to moderate some of his more extreme policy plans) was in the process of being dissolved, to be replaced by more hawkish figures such as neoconservative John Bolton as the new National Security Advisor and Larry Kudlow as the new Director of the NEC. 

On that occasion we warned that “one can reasonably wonder when the other two former generals that currently are in key government positions, James Mattis as Defense Secretary and John F. Kelly as Chief of Staff, will also depart, leaving room for less moderate substitutes.” We also added: “As the example of Jay Powell shows, the choice of people in charge determines the credibility, policy direction and ability to deliver of institutions.” 

The time for both Kelly and Mattis to leave has now come. 

Meanwhile, Jay Powell’s position has come under attack, as has Steve Mnuchin, the Secretary to the Treasury who de-facto chose him. If these changes were not enough, the US anti-ISIS envoy Brett McGurk also quit over Trump’s decision to withdraw US troops from Syria, which was made almost at the same time as the decision to withdraw about 7000 troops from Afghanistan. 

The impression one gets from this raft of news is that all the key, respected and moderating advisors to President Trump have left, some abrupt decisions on Syria and Afghanistan have been taken, and this political shake-up could continue if Mnuchin were also to be let go (or decides to quit) and Powell’s position were to be put under further scrutiny. 

From a geopolitical standpoint, the risk now is that the US might become more vulnerable at the same time as its forces are withdrawing from hostile theatres of war, as key members of the administration coming from the military have left. As we warned in our review of the US mid-term election results, Trump’s loss of the House of Representatives would have meant a re-focusing of his attention on foreign policy, considering the limited ability the executive branch has to dictate the agenda on domestic and economic issues independent of Congress, as proven by the government shutdown (which we also thought would become likely after the Democratic victory in the House). 

From a financial market perspective, as we have observed in Turkey, India, and Argentina, when the independence of a central bank comes under attack (a fortiori if we talk about the most influential central bank in the world, the US Federal Reserve), serious market volatility tends to ensue. Hopefully Trump will refrain from continuing to put pressure on the Fed and its chairman, otherwise 2019 could get off to a very troublesome start.  

by Brunello Rosa

17 December 2018  

As 2018 comes to an end, central banks are taking centre stage once more. As we discuss in greater detail on the second page of this Viewsletter, economic activity is slowing down globally. Economic activity is reverting to trend growth, and in Q3 experienced episodes of contraction in Japan, Germany, Sweden, and elsewhere. In spite of tightening labour markets, closing output gaps, and rising salaries, core inflation in developed markets (DMs) remains subdued while headline inflation is being dragged down by falling oil prices. (Low core inflation has been due to technological innovations, labour re-organisation and weaker unions, and disruptions in global supply chains, among other factors, all of which are contributing to keep Phillips curves flatter than they would be otherwise). In this environment, central banks in DMs can afford to adopt a more cautious approach to monetary policy normalisation, while some central banks in emerging markets are increasing rates to defend their currencies and achieve inflation targets.  

Last week, the European Central Bank kept its policy stance unchanged and confirmed its intention to terminate its net asset purchases at the end of this year. It will proceed with full reinvestment for an extended period of time after the first rate increase, which is unlikely to occur before Q4 2019 (and will possibly occur later than that, given the balance of risks is shifting to the downside). Earlier in the month, the Bank of Canada kept its overnight rate unchanged at 1.75% and struck a dovish note, citing lower oil prices and constrained investment. 

This week, the Fed is expected to increase its Fed funds target range by 25bps to 2.25-2.50%, and suggest a slower pace of policy tightening going forward. The Bank of Japan is expected to keep its policy stance unchanged and extremely accommodative, until core inflation starts to rise convincingly. The Bank of England is also expected to remain on hold this week, as it observes the unfolding of the Brexit saga. Finally, we expect the Riksbank to wait until 2019 before raising its repo rate, and we expect the Swiss National Bank to shadow very closely any changes in the ECB’s policy stance. 

In emerging markets, while the Turkish CBRT left its policy rate at 24% last week and while the People’s Bank of China continues to provide monetary accommodation as part of the broader stimulus package implemented by Chinese authorities to cushion the effects of trade wars with the US, the Reserve Bank of India, which is in the middle of the crisis with the government over its independence, left its key policy rate steady at 6.5% on December 5th as part of its gradual tightening process. On December 12th, meanwhile, the central bank of Brazil voted unanimously to hold its key Selic rate steady at 6.50%, amid soft GDP growth and below-target inflation. In contrast, last Friday the central bank of Russia unexpectedly raised its benchmark one-week repo rate by 25bps to 7.75%, in order to limit rising inflation risks, given the upcoming VAT rate increase expected to occur on January 1, 2019. This move followed the unexpected decision by the South African Reserve Bank to raise its repo rate by 25bps to 6.75% at the end of November (its first hike since March 2016) given rising inflation on the back of a weakening currency.

With global growth decelerating, inflation remaining subdued in DMs and rising in some EMs (given EM’s weaker currencies), still-constrained fiscal policy, and financial markets becoming volatile and nervous, central banks will continue to play a crucial role in shaping macroeconomic and market dynamics also in 2019 and subsequent years. 

by Brunello Rosa

10 December 2018  

The victory by Annegret Kramp–Karrenbauer (AKK, for short) in the contest to replace Angela Merkel as CDU party leader ensures a level of short-term continuity in Germany’s political affairs. It is, however, unlikely to settle Germany’s political situation once and for all. As we discuss in depth in our travel notes from Berlin, AKK was most closely aligned to Angela Merkel of the three contenders for the party leadership, but also the least charismatic and the least able to promote the shift to the right that the party needs to carry out in order to regain the popular support and votes that have gone to the AfD in the last few years. 

The other two contenders for the CDU leadership, Friedrich Merz and Jens Spahn, drove the agenda of the party conference and are likely to shape the CDU’s political trajectory in coming years, for a number of reasons. First of all, AKK defeated Merz in the second round of the election only by a very tight margin, 51.75% to 48.25%. The fact that Wolfgang Schäuble decided to support Merz in his bid for the candidacy and reportedly did not applaud Merkel’s final speech as CDU leader shows that the party is profoundly divided on the question of which direction to follow. Second, AKK will have to re-affirm and consolidate her power over the next few months, which will feature a number of important elections: European parliament (on May 26th, 2019), Brandenburg and Saxony (September 1st, 2019) and Thuringia (October 27th, 2019). The two defeated candidates might even hope for a poor CDU showing in these elections, to demonstrate that the party needs a radically new course of action (led by them, of course) to regain lost votes and centrality in German politics. 

Third, the tide of history currently appears to favour right-wing candidates (such as Merz and Spahn) able to appeal to the anti-immigrant sentiment now prevalent among the German and European population. And fourth, the anti-European forces within the EU as well as outside the EU (in America and Asia) will give AKK a hard time in the coming years, and will continue to push for the dis-integration of the EU.  

Angela Merkel can rightly claim a political victory with AKK’s election, following upon a number of political defeats. Merkel can now plan for her exit from German politics in less haste. She has bought a few more months to decide whether she want to bid for a big EU job, in order to make sure the European project does not crumble following her political departure. The fact that the European People’s Party (EPP) has chosen Manfred Weber as Spitzenkandidat for the EU Commission presidency means that Germany and the EPP more widely have already started to plan for a post-integration future, a future in which the EPP will have to deal with the populist parties now proliferating throughout Europe (as we discuss in our recent travel notes from Italy). 

But time is running out. As the “Gilettes Jaunes” protests in France show, anti-élite, anti-establishment and inherently anti-European anti-Western sentiment is on the rise even in the country with the most explicitly pro-European leader in Europe, i.e. French President Macron. There is a risk that, if this anti-European sentiment ends prevailing, then even if Macron and Merkel/AKK were to come out with the best plan to complete the European Union and the Eurozone, that plan would still be rejected by the respective populations of European countries, thereby de facto starting the process of European dis-integration, whether the establishment likes it or not. 

All the above is not just a list of interesting political considerations. As we discuss in our recent market update, geopolitical events and the political economy of nations (such as those we discuss in our “geopolitical corner” column) now have a direct impact on markets’ prices. So, while AKK’s victory might provide a sigh of relief for market participants in the short run, it cannot prevent them from entering a rollercoaster ride in the next few months.

by Brunello Rosa

3 December 2018

As we predicted in our column last week, the meeting between US and China that occurred on the sidelines of the G20 summit in Buenos Aires resulted in an agreement that will allow the countries to continue negotiating with one another on trade during the next few months. The US has agreed to postpone by three months its planned increase in tariffs, from 10% to 25%, on $200bn worth of Chinese goods exported to the US; tariffs which would have otherwise gone into effect on January 1st, 2019. 

As we expected, this meeting was not the place at which a full-fledged agreement could take place,  given the unresolved issues that exist between the two countries (especially in terms of the protection of intellectual property and the imbalance resulting from the closed nature of the Chinese economy relative to the American economy) and the deeper technological competition that is underlying their “trade skirmishes” with one another. All the same, this Christmas truce is a welcome development, as it removes one element of uncertainty for market participants on the verge of closing their books for 2018. 

In contrast, the communique released at the end of the G20 summit is not likely to be a step in the right direction. Apart from being vague in general, there are three clear commitments the G20 fails to make in it. First, the communique does not explicitly condemn “protectionism” as it used to, but instead only says that world leaders “note current trade issues…recognize the contribution that the multilateral trading system has made”, and that the “system is currently falling short of its objectives and there is room for improvement.”  

Second, the G20 failed to endorse the UN’s Global Compact For Migration after a number of countries, including the US, Hungary, Switzerland, and Italy, explicitly pulled out or showed reservations. 

The communique simply says that “large movements of refugees are a global concern with humanitarian, political, social and economic consequences. [G20 leaders] emphasize the importance of shared actions to address the root causes of displacement and to respond to growing humanitarian needs.” 

Finally, the G20 communique confirms that Europe remains united in its support for the Paris agreement on climate change, whereas the US has confirmed its withdrawal from the agreement (only one day before the COP24 climate summit in Poland is set to begin), failing to put the weight of the entire G20 behind global environmental commitments.  

Somebody willing to see the glass half full could say that at least this G20 meeting ended with less acrimony than did the G7 meeting in Canada in June 2018, where even the pictures taken showed tensions among various world leaders. For those inclined to be optimistic at the beginning of this festive season, one can perhaps focus on a few factors that are now lifting investor sentiment. In addition to this new truce in the US-China ”trade war”, there is also the more cooperative approach that has recently  taken by the Italian government regarding its budget (an attempt to prevent the opening of a excessive deficit procedure by the European Commission early next year), as well as the less hawkish tone taken by US Federal Reserve chairman Jay Powell in his recent speech on financial stability. 

All of these factors, though somewhat clouded by the possibility of there being a negative reaction should the UK parliament reject the deal between the UK and the EU on the British withdrawal agreement on December 11th, might provide positive support to risky assets as 2018 comes to an end. Still, given the number of risks that remain, investors are likely to stay cautious during the final part of 2018 and into 2019.

by Brunello Rosa

26 November 2018

The G20 meeting scheduled to take place on November 30th and December 1st in Buenos Aires could be an occasion for US President Trump and Chinese President Xi Jinping to try to resolve trade tensions that have been escalating for months, when the two meet privately on the sidelines of the event.

As we discussed in our report earlier this year, this G20 meeting in Argentina was already going to be quite an odd affair, considering it is going to be hosted by a country that had intended to show to the world that it was open for business again thanks to the reforms introduced by the liberal-conservative government of Mauricio Macri, but instead has rapidly fallen back to being an economic “problem child,” given its mis-management of the economy, monetary policy, and public relations (with heavy consequences for financial markets as a result). These have forced Argentina to yet again seek the help of the IMF, an organization that is much-hated in the country. The usual themes will be on the agenda at the G20 meeting, including finance, economic sustainability, “digital divide,” agriculture, energy, and – above all – trade and investment. 

The attention of all investors, business leaders and international policy makers will however be devoted to the meeting between Trump and Xi, which will be held just a few weeks before the threatened increase in tariffs, from 10% to 25% on $250bn worth of Chinese exports to the US, is scheduled to take place on January 1st, 2019. As we discussed in our recent travel notes from China, we do not expect Trump and Xi to discuss, much less to agree upon, tedious and detailed trade agreement terms.

Rather, the best one can hope for is that a cosmetic agreement to continue trade negotiations will be reached in principle. Whether or not the planned increase in tariffs would then be suspended is currently unclear. But the chances of Trump and Xi reaching a deal are still small for the time being, as the two sides are still very far apart in terms of what they are willing to compromise on.

The Chinese economy has been hit hard by the increase in tariffs adopted by the US earlier this year (as have Chinese equity markets), so China might be inclined to offer more than it has done so far in terms of opening up its economic system. At the same time, there are limits on what the Chinese are willing to give up in order to keep world trade relatively freer. As for the US, as we discussed in our recent review of the US mid-term elections, the hardline position on China has bipartisan support in Washington, as it remains popular among the US electorate. As such, the space for a compromise between the two countries is limited. In addition, there is a much deeper, underlying confrontation taking place between the US and China within the technological and geo-strategic battlefields, one that may be on the verge of becoming a new “cold war”.

What this means is that, behind the handshakes, pats on shoulders, and pompous declarations that occur at summits like the G20 meetings, any agreement of substance reached there is likely to remain limited. That will continue to weigh on investor sentiment in weeks, months, and likely even years to come.  

by Brunello Rosa

19 November 2018

Before the October market sell-off and the recent outbursts of political risk, the direction of monetary policy stances taken by the major central banks over the next 12 months seemed to be pretty much set, within limited “confidence intervals”. The Fed seemed destined to increase its Fed funds rate once again in 2018 and another 3-4 times in 2019. The ECB seemed destined to finish QE in December 2018 and then carry out a first rate increase around September 2019. The Bank of England seemed likely to continue its “gradual and limited” rate normalisation process, and the BOJ to only start removing some of its extraordinary measures of monetary accommodation very gradually in 2019. 

However, the October sell-off did take place, as a result of fears over a global growth slowdown, with China having joined the economic deceleration in the Eurozone, Japan and EMs, and oil prices having risen substantially - given renewed US sanctions on Iran. The correction carried with it a tightening in financial conditions, exacerbated by the further strengthening of the USD as compared to the EUR, GBP and most EM currencies.  The US economy is still in very good shape, adding jobs at an extraordinarily good pace given the point in the business cycle it appears to be in. That is the reason why the Fed is likely to carry on with its additional 25-bps rate increase in December (as hinted in the November FOMC statement), taking the upper end of the Fed funds range to 2.5%, in spite of President Trump’s discontent with such increases. At the same time, however, the strength of the dollar, the impact on long-term rates deriving from the reduction in the Federal Reserve’s balance sheet (the so-called Quantitative Tightening) and the economic hiccups coming from Europe and Japan might convince Jay Powell to display some caution regarding future rate hikes, leaving the door open to some pauses in the normalisation process. 

Indeed, in Q3 Germany recorded a 0.2% contraction in its quarterly GDP, mostly due to the impact on the car industry of new regulations on emission standards. Italy’s economic performance was also flat, with 0% growth registered in Q3, a result of the collapse in business investment due to the uncertainty generated by the government’s bickering with the EU Commission on the budget. Q3 GDP was also negative in Japan (-0.3% q/q), where natural disasters weighed on personal consumption, investment levels and exports. These sobering figures suggest prudence is likely to be shown in the next monetary policy announcements by the ECB and the BOJ. As far as the ECB is concerned, in a recent speech President Draghi remarked how the Governing Council will use the new set of forecasts that become available in December to decide on the Bank’s re-investment policy, forward guidance on rates, and the possible adoption of a new round of long-term repo operations (LTROs or TLTROs). The BOJ, as we discussed in our recent analysis, remains very cautious regarding any possible changes to its policy stance. As such, the newly available data on GDP growth will only serve to confirm the BOJ’s prudent position. 

As far as the BOE is concerned, as we discussed in our recent trip report, everything is dependent on the outcome of the Brexit process. As Governor Carney said during his latest press conference, a swift resolution of the uncertainty surrounding Brexit negotiations could unleash pent-up demand for consumption and investment, leading to an acceleration of the BOE’s normalisation process. However, recent developments on the Brexit front seem to suggest instead that a political (and possibly economic) crisis might be needed to break the Brexit impasse. In that case, the BOE can only remain in a wait-and-see mode, ready to react in either direction depending on developments impacting supply, demand, and the FX rate. 

In conclusion, the possibility of a more gradual policy normalization by the major central banks, the aggressive monetary easing adopted by China’s PBOC and the waivers given by the US to several countries on oil imports from Iran (which led to a substantial fall in oil prices) have helped the recent recovery in risky asset prices. 

by Brunello Rosa

12 November 2018

Important events occurred both in the US and the UK last week, events which deserve plenty of attention from investors. In the US, President Trump’s Republican Party managed to increase its majority in the Senate and win the majority of gubernatorial races, but lost its control of the House of Representatives. As we will discuss at length in our upcoming report on the results of this election, the Democrats managed to elect to Congress a number of high-profile first time politicians (including Alexandria Ocasio-Cortez), but the “blue wave” many had expected did not materialise. The Democrats will now be able to scrutinise the Trump administration’s actions more closely (and possibly even launch an impeachment process), and choose whether or not to block legislation initiatives the Republicans might put forth, such as a new round of tax cuts or a serious infrastructure spending program. Nevertheless, if the Democrats want to win the presidential race in 2020, they need to start trying to identify a suitable candidate soon. In fact, in spite of losing control of the House, Trump felt emboldened by the election results. Following the election, he pushed attorney general Jeff Session to resign, thus putting the future of the Mueller’s investigation in doubt. With Trump's domestic agenda perhaps likely to be blocked by the Democratic majority in the House, will Trump focus on foreign policy instead, as most presidents tend to do during the second half of their terms in office?  As we discussed in a recent report, there is a risk of there being a wag-the-dog moment in 2020, if Trump is tempted to embark upon military adventures in order to secure a second term. 

Meanwhile, the new round of sanctions on Iran has indirectly led to a fall in oil prices, as other countries increased their production. Oil prices have now entered a bear market, after having recently touched their 2018 highs. In forthcoming research, we will update our outlook for oil in coming years. If a new round of US tax as cuts becomes less likely, the risk of inflation surprises would be reduced, and the likelihood that the Fed will need to speed up its pace of tightening will be lower as a result. This has helped the bull flattening of the US Treasury curve, with the long end of the curve remaining in check in spite of the near certainty of there being a fourth 25-bps increase in the Fed funds rate in December, after this week’s FOMC meeting. The long end of the yield curve also remains anchored by persistently low Japanese long-term yields. (In our recent BOJ report we discuss why we believe this is likely to continue well into 2019.)   

On the other side of the Atlantic, as we discussed in our recent UK trip report, Brexit negotiations are now entering crunch time. The days ahead will be crucial; an agreement between the EU and the UK ideally needs to be reached in time for EU President Tusk to call a special EU summit by the end of November and pass the “deal” through the British parliament before Christmas, leaving enough time for other European parliaments to ratify this “divorce deal.” This schedule might prove to be too optimistic, however. There is a risk that a political and economic crisis might first be needed in order to break the impasse that exists between the UK and the EU. 

As a proof of this, on Friday the British government lost another key member: Transport Secretary Jo Johnson (brother to former foreign secretary Boris) resigned, while calling for a second referendum in which three choices should be available to voters: accept a deal potentially brought back by Theresa May, leave the EU without a deal, or remain in the EU. This week might prove essential to see whether the government and the EU might at least agree on a withdrawal deal. (Whether the British government's cabinet and, more importantly, Britain's parliament will accept such a deal, is of course a different matter). It will be some time yet before all this uncertainty is dissipated. 

by Brunello Rosa

5 November 2018

In the inaugural column of this Viewsletter, we asked: Is a German “Grand Coalition” Necessarily Good News?. Even though the creation of such a coalition had resolved the uncertainty related to the German government’s formation (a process that lasted more than six months), nevertheless we highlighted the presence of a series of downside risks resulting from it. We wrote: “if the grand coalition fails, there is a risk of making euro-skeptic AfD and FDP stronger…This means that, at the end of this experience (in 3-4 years), Germany runs the risk of finding itself with an even more fragmented political spectrum, unable to form a governing coalition, and express a government strong enough to complete the European integration process, when centrifugal forces could be even stronger.”

The results of state elections in Bavaria and Hesse, which saw the collapse of the SPD and the CDU/CSU and the rise of the AfD and the Greens, leading to Chancellor Merkel’s decision not to run again for her party's leadership in December, showed that those concerns were well placed. The risk is that Germany will soon experience a government crisis in which (among other things) Merkel could be forced to step down from her Chancellor’s position much earlier than has initially been anticipated. In fact, of the various contenders now being considered for the future leadership of the CDU, a possible “co-habitation” between Merkel as Chancellor and someone else as CDU leader could be envisioned only with Merkel’s chosen successor, Annegret Kramp-Karrenbauer, while a diarchy with either Friedrich Merz or Jens Spahn is difficult to imagine. The fourth potential candidate, Armin Laschet may therefore eventually emerge as a good compromise candidate able to reunite the party (as we discussed already in our recent trip report).   

As we will discuss in detail in forthcoming research, Merkel’s eventual departure has a number of consequences at the domestic as well as international level. Domestically, her departure means that the CDU will have to move more towards the right. This will also occur because of the parallel rise of the Greens, a party that has occupied a strategic position within Germany’s political spectrum, being more conservative than the SPD on fiscal issues yet more progressive on migration, social rights and technological evolution. The Greens now occupy that centrist political space that the CDU wanted to cover within this “GroKo”. So the CDU will instead have to try to re-absorb the moderate/conservative votes that have abandoned it, votes that are temporarily “parked” with the AfD. 

From an international perspective, as we discussed in a recent trip report, there are a number of implications as well, especially at the European level. First of all, Merkel’s departure would make the window of opportunity in which to promote EU and EZ reform in the next few years even smaller than it was already (or even make it virtually non-existent). Secondly, if Merkel were to eventually decide to run for a top European job (something she is currently denying thinking about), it would fundamentally change the ongoing European musical chairs game, as – at the very least – France would demand to be fully “compensated” with adequately powerful appointments, such as the head of the European Central Bank, in response. Finally, after Merkel’s departure, the possibility of an agreement to rule the EU between the European People’s Party and the populist front, emerging after the May 2019 EU election, becomes more likely. 

Meanwhile, European tensions related to Brexit and budget negotiations will continue to see German bunds in high demand, implying long-term yields being lower than what economic fundamentals (growth, employment, inflation, etc.) would typically justify, with well-known consequences even for long-dated US Treasury yields.

by Brunello Rosa

29 October 2018

After three weeks, our column now returns to discuss the second round of Brazil’s presidential election, which was held yesterday evening. The election resulted in the victory of right-wing candidate Jair Bolsonaro, the leader of the Social Liberal Party, over his opponent Fernando Haddad, of the Workers’ Party. Bolsonaro received 55% of the votes, Haddad 45%. Most of the analysis we provided in our previous column on Brazil in early October, when Bolsonaro won the first round of the election with 46% of the votes, is still valid today. Now that he has won the final round of the election, we want to focus on his economic plans, and discuss what type of president he might be. To begin with, the victory of Bolsonaro marks the return of a sui-generis “populist” extreme right-wing candidate to power in Latin America, after decades in which populist leaders had been coming mostly from the left of the political spectrum (e.g. Hugo Chavez and Nicolas Maduros in Venezuela, Evo Morales in Bolivia, etc.). His anti-democratic rhetoric and continued defence of the military dictatorship of the 1964-1985 period also make him more akin to leaders like Chile’s Augusto Pinochet (whose dictatorship lasted from 1973 to 1990) than to recent examples of left-wing populists. 

Second, Bolsonaro’s economic plan, which was prepared by Paulo Guedes (a PhD graduate from the University of Chicago, former investment banker at Bozano Investimentos, and one of the founders of BTG Pactual), is to be centred around fiscal reform, budget discipline and the reform of the pension system (in spite of the fact that the military is one of the major beneficiaries of the generous system that currently exists in Brazil). These actions would be accompanied by an aggressive plan of privatising state-owned enterprises (such as Banco do Brasil and oil company Petróleo Brasileiro), which would be expected to raise around 800 billion reais ($215 billion), enough to reduce Brazil’s federal debt by a fifth. Very much like Donald Trump, however, Bolsonaro, even while remaining market friendly and appointing market-friendly advisors (such as the former president of Goldman Sachs and current director of the National Economic Council Gary Cohn, in Trump’s case), will have to deliver to his electoral base, a population that is among the hardest hit by the economic recession Brazil had faced.   

In this respect, Bolsonaro is unlikely to deviate too much from the path indicated by the archetype of all right-wing populists in Latin America, namely Juan Domingo Peron of Argentina. (Peron, unlike Pinochet who came to power by way of a military coup in 1973, was elected to office). The US under Trump is likely to remain very sympathetic to Bolsonaro’s Brazi, and unlikely to slap tariffs on Brazil’s exports. The markets are likely to be enthused by Bolsonaro’s victory as well; as can already been seen in the recent excellent performance of Brazilian equities (+7% in a week, +13% year to date, in spite of the ongoing sell-off/correction that has been especially impacting EMs). Bolsonaro’s victory is therefore likely to strengthen the BRL relative to the USD and other EM currencies, thereby opening up the space for a cut in interest rates in coming weeks (as inflation in Brazil, at 4.5%, is under control, and real policy rates, at around 2%, have room to be trimmed). 

As such, assuming that Bolsonaro will be a mix of Trump, Peron, and Pinochet (perhaps even to the point of severely reducing Brazil’s democratic rule) how will his presidency be remembered? There have been a number of studies on the economic impact of Pinochet’s combination of liberist policies - including his reform of the pension system - and authoritarian governance. Most of these studies were partial, if not heavily biased, especially given the explicit support provided to Pinochet by the then-champions of neo-liberism, Ronald Reagan and Margaret Thatcher. 

However, even more balanced evaluations suggest that Pinochet’s policies had an overall positive impact on Chile’s economy, even if the costs in terms of political, social and human rights were immense. At the same time we would consider it wise not to forget the lesson that Rudiger Dornbush and Sebastian Edwards gave us in 1990 in “Macroeconomic Populism in Latin America”: “populist policies do ultimately fail; and when they fail it is always at a frightening cost to the very groups who were supposed to be favored... the macroeconomics of various experiences is very much the same, even if the politics differed greatly.”

by Bruello Rosa

22 October 2018

After several weeks of equity re-pricing and heightened volatility, markets started to stabilise near the end of last week. As we discussed in an in-depth report, this sell-off episode was both healthy and unsurprising. This is primarily because further increases in equity valuations would have sent prices increasingly far above their historical ranges. US equities were already 40-50% above their average PE ratios, and already three standard deviations above their average CAPE ratios. Indeed, as we discussed in our strategic asset allocation report for 2018, investors this year should have considered moderate risk-taking only within the context of defensively positioning themselves. 

For now, there remains enough momentum in the economy (supported by global monetary and fiscal stimulus) to offset some of the negative factors affecting risky asset prices. Such negative factors may include rising inflation, global economic deceleration and divergences in growth, rising interest rates (coming from various central banks, including the Bank of Canada this week), trade skirmishes or trade wars impacting Chinese growth, geopolitical tensions, and a number of idiosyncratic instances of risk each of which has the potential to cause widespread damage if badly handled (in DMs chiefly Italy, but also the UK; in EMs, Turkey, Argentina and a number of other countries). Eventually, however, perhaps by 2020, these risks are likely to outweigh the factors that have been supporting the economy, and the market will correct. In the meantime, for the first time since the financial crisis (apart from very short periods during 2014-15) the interest rate offered by US 3m T-bills is higher than headline and core inflation, offering a real-return alternative to equities. 

This recent sell-off has occurred just before the US mid-term elections, and perhaps partly because of them. As discussed in our recent report, the possibility of a divided Congress makes it less likely that legislation will be passed that would allow the government to avoid the “fiscal cliff” that awaits the US when the effects of tax cuts passed earlier this year fade in late 2019. But there are also a number of other crisis situations that remain unresolved and will weigh on the performance of asset prices. 

While the situation in Turkey seems to be stabilising (following the release of Pastor Brunson), developments in the Brexit negotiations and in Italy appear increasingly unfavourable. This past Saturday there was a large rally in London to ask for a second referendum; the likelihood of a no-deal scenario is increasing by the day, and the prospect of a special EU Council meeting being held in November has been shelved. 

Last Friday, Moody’s downgraded Italy’s creditworthiness by one notch to Baa3 (with a stable outlook) - i.e. just one notch above “junk” status. This downgrade occurred as a result of the prospective deterioration of Italy’s fiscal position following the Italian government’s proposed budget for 2019, which foresees an increase in the budget deficit. The EU Commission sent a harsh letter urging the government to reconsider its generous spending plans, asking for a reply to letter to be given by Monday 22 October. During the weekend, an extraordinary Council of Ministers meeting, which was called to resolve the fiscal amnesty dispute that has emerged within the governing coalition, failed to approve an alternative deficit profile, which is what would be needed to prevent an excessive deficit procedure from being opened. This occurred in spite of Finance Minister Giovanni Tria’s reported request that the government consider a reduction in the planned deficit for 2019, to 2.1% from the current 2.4% .

Thus, the deficit stand-off is likely to continue until mid-November, when the budget will be either approved or rejected by the Commission. In the meantime, on October 26 S&P might follow Moody’s and cut Italy’s credit rating. Italy is currently alone in this battle against the rating agencies, the EU, and in particular the market (the 10y BTP-Bund spread having reached 340bps last Friday). Mario Draghi, while striking a conciliatory tone and being confident that a compromise with Italy would be reached, recently said that for idiosyncratic situations as might occur there is still the possibility of OMTs, and any extra call for ECB action is misplaced. This week, the ECB will likely buy more time before announcing any details of its reinvestment plans, which could either help Italy or put additional pressure on it.   

by Brunello Rosa

15 October 2018

Last week the IMF released its latest World Economic Outlook. In it, the IMF lowered its forecast of global growth in 2019 (by 0.2%, to 3.7%, the same rate of growth it predicts to occur in 2018), citing a number of “rising risks,” including multilateralism being challenged worldwide, the ongoing US-China trade dispute possibly morphing into a full-fledged trade war with global implications, the possible impact of continued Fed monetary tightening on US and global financial conditions, and rising political and economic risks in the EU. This outlook downgrade might have contributed to the continuation of the ongoing sell-off in global equity markets, which we discuss in an upcoming report. Last week, MSCI AWCI lost 3.9%, the S&P500 4.1%, Eurostoxx 50 4.5% and MSCI EMs 2.1%, while volatility rose above its 10-year average.

A focus on European political risk is warranted given developments that occurred during the past weekend. In Germany, the CSU (the CDU’s sister party in Bavaria) “won” the regional election with such a huge loss of votes, falling from an absolute majority to only around 37%, that it would be more correct to describe this electoral performance as a historical defeat. This election is important for a number of reasons. At a local level, the right-wing populist AfD, which entered the regional parliament for the first time with 11% of votes, is proposing an alliance with the CDU to govern the Land. Such an alliance would be another example of the “Austrian model”, wherein a right-wing populist party offers its support to prop-up a government led by the Christian-democratic party. (Italy’s Deputy PM Matteo Salvini is also actively pursuing this model, at the European level). For the time being, it seems that the CSU will look for other allies to govern with, but things may change in future. At a national level, the CSU’s defeat in Bavaria will make its positions even more radicalised, further putting at risk Angela Merkel’s fragile grosse coalition.  Finally at the European level, the more the German government moves to the right, the more likely it is that the necessary advancement of the EU and the EZ towards more integration will be slowed down.   

In the UK, negotiations for a deal to be presented at the EU summit on Wednesday broke down on Sunday. The UK rejected the draft withdrawal treaty proposed by Brussels, as it was unwilling to accept the backstop that would allow Northern Ireland to remain within the EU customs union. This stand-off in the negotiations might imply that the extraordinary EU Council meeting that will be held in November to finalise the deal might not take place, and the UK might leave the EU without a deal. The 27 EU ambassadors have been summoned by chief negotiator Michel Barnier to participate in urgent meetings. Last week, the BOE warned that GBP 41 trillion of derivatives will face legal uncertainty after Brexit on 29 March unless the EU takes action to ensure the continuity of existing rules. 

Finally, European governments will have to present their Draft Budgetary Plans by the midnight of 15 October, and all eyes are on Italy’s budget, which is at serious risk of non-compliance, which if it were to occur could mean the EU opening an excessive deficit procedure (EDP) for the country. The 10y BTP/Bund spread remains above 300bps, while Deputy PMs Luigi Di Maio and Matteo Salvini remain defiant and have said that the government will not backtrack on its budget plans, regardless of mounting market concerns. This increases the likelihood of an EDP being opened and downgrades by rating agencies occurring (in October, Moody's and S&P are expected to announce their ratings decisions). In Europe, Italian assets were the worst performers during the week, with FTSEMIB down by 5.4%.   

by Brunello Rosa

8 October 2018

Jair Bolsonaro, the populist leader of Brazil’s right-wing Social-Liberal Party (PSL), won the first round of the country’s presidential election last night, with around 46 percent of the votes. His closest rival, the Workers’ party (PT) candidate and former mayor of São Paulo Fernando Haddad, trailed behind Bolsonaro with only 29 percent of the votes. Bolsonaro’s party is also expected to receive the most votes in in the accompanying parliamentary elections. Other presidential candidates are even further behind in the polls. For the first time since 1994, Brazil’s president might not come from either of the two major parties, the centrist Brazilian Social Democracy Party (PSDB) or the leftist Workers’ Party (PT). The incumbent president Michel Temer, of the Brazilian Democratic Movement Party (PMDB), decided not to run when his approval rating sank into the single digits.

As we discussed in a detailed country report published last week, Brazil’s enormous political divisions are currently preventing the country from capitalizing on its equally huge economic potential (an example of which is Brazil’s successful aeronautical industry, which competes efficiently on the world stage). After experiencing the worst recession in the country’s recent history, a recession in which it lost around 8% of its GDP between 2015 and 2016 and witnessed one of its worst ever corruption scandals (which, in turn, led to the imprisonment of former President Inácio Lula da Silva and the impeachment of his successor and protégé Dilma Rousseff), Brazil has been left with deep political scars, negatively influencing what had already been a massively divided society to begin with. 

Congressman Bolsonaro has used rhetoric typical of right-wing populists around the globe, resorting to so-called “politically incorrect” expressions against women, minority groups, and disadvantaged people generally. On the other hand, unlike other right-wing populists, Bolsonaro’s agenda is fiscally conservative, focused on the reduction of public spending and taxes, as well as on privatisation.  He is also in favour of structural reform, such as the reform of the pension system. If his agenda were implemented and worked, Brazil’s growth potential could be revitalised. Perhaps as result of this focus, the Brazilian real (BRL) appreciated against the USD last week, with USD/BRL falling by 5.4% on a weekly basis (to 3.841). Brazilian equity prices are also up, by more than 8% since the beginning of the year.  

It is still possible for other candidates to win the second round of the election, three weeks from now. If the support for other left-wing and centrist candidates is consolidated by Haddad, and if Haddad then manages to stage a comeback (helped also by support from numerous political groups, such as EleNão, that have emerged in the past few months to protest the ascent of Bolsonaro), then Bolsonaro might still not become Brazil’s next president. At this stage, this seems to be a relatively improbable scenario, however. Bolsonaro’s popularity has increased dramatically during the past few months, especially after being stabbed by a left-wing extremist during an election rally in early September. Bolsonaro’s efficient social media campaigners managed to use that  event to his favour. 

If Bolsonaro’s victory in the first round is followed by another victory in the second round, there will be yet another strongman on the world stage, this time in a key BRIC and G-20 economy. Bolsonaro would join an already numerous group that includes Trump, Putin, Xi Jinping, Orbán, Kaczynski, Erdoğan, Duterte, and Modi - to name only the most preeminent of such politicians. Bolsonaro might even be one of this group’s most explicit believers in the desirability of autocracy: “I am in favor of a dictatorship … We will never resolve serious national problems with this irresponsible democracy,” he once said. Bolsonaro might also set the stage for the return of populist right-wing leaders in Latin America, a year before Argentina’s presidential elections will be held. We have discussed in a previous column (on March 19th, 2018) the risks the world faces from the increasing number of autocratic leaders, at a time when tariffs and protectionism are rising and global economic growth is slowing. By definition, strongmen do not want to avoid engaging in overt confrontation (on borders, tariffs, policy actions, etc). As such, their ascendance means that open conflicts, of various types, could unsurprisingly ensue. 

by Brunello Rosa

1 October 2018

This week, the final quarter of 2018 begins. During the previous quarter, Q3, the global economy continued to grow, but the cyclical acceleration that began in 2017 had already ended in most developed markets (DMs), with the exception of in the United States. In emerging markets (EMs), declining global liquidity and domestic fragilities triggered periphery-to-core flows, with Argentina and Turkey being the most highly impacted countries. The Fed and Bank of England continued their policy normalisation plans (though their plans differ widely in the pace at which they will raise rates), while the ECB and BOJ both remained extremely accommodative. A number of EM central banks had to embark upon “defensive” policy rate hikes in order to prevent further depreciations of their currencies. 

As discussed in the latest edition of our strategic asset allocation and market update, global equities rose by around 2.5% during Q3, led by US stocks, while market volatility remained subdued. In contrast, EM equities lost more than 4% on a quarterly basis and 20% since their highs of January 2018, with a number of stock indices having entered “bear market” territory. In the fixed-income space, 10-year bond yields remained broadly stable during Q3, as strong demand compensated for an increasing supply and rising inflation. Bond indices in DMs and EMs fell marginally, however. In commodity markets, oil prices remained around USD 75 per barrel, supported by supply constraints (e.g. output declines in Venezuela and sanctions on Iranian exports), while copper prices fell more than 10% as a result of concerns about the potential impact a US-China “trade war” on global growth.