WEEKLY COLUMNS (ARCHIVE)

---

by Brunello Rosa

3 April 2023  

The indictment of Donald Trump took place last week. The former US president will have to surrender to the New York judiciary on Tuesday, two weeks after he had anticipated to occur. He is accused of having used electoral campaign funds to buy the silence of “Stormy Daniels,” a porn-star, regarding an affair they had at the time when Trump was married to Melania, and she was expecting their only child, Barron. Daniels’ silence may have also altered the course of the electoral campaign that led to Trump’s victory in November 2016.

Trump will likely use this scandal as proof of the establishment’s attempt to keep him out of power, against the will of the “true Americans” he purportedly represents. This will make the 2024 electoral campaign even more tense than one could have anticipated, and the risk of civil unrest will increase dramatically, both before the election - to prevent voting from taking place - and after it, if Trump again loses and claims the results were fraudulent. 

Western countries, and even G7 countries, have already experienced similar situations, the most similar being Italy under Berlusconi. But the US is the beacon for Western democracies and cannot afford to stage such a depressing “show.”

But the US is not the only Western country that is exhibiting a worrying collapse in the quality of its political leaders. In the UK, the populist leadership under Boris Johnson led the country to implement the referendum on Brexit with a “hard-leave”, a rare example of a self-inflicted wound that will be felt for generations, and will be hard to undo. Luckily, the Tory leadership is now in the safer hands of Rishi Sunak, after the disastrous interregnum of Liz Truss and Kwasi Kwarteng.

In Germany, after the fall of Merkel, a clear successor in terms of charisma has not yet emerged in any party. On the right side of the political spectrum, Friedrich Merz is facing the challenge of unifying the CDU behind his liberal positions. On the left, Olaf Scholz is having a hard time exerting leadership over his coalition, in which Christian Lindner is facing the possibility for his Liberal party not to re-enter parliament. The Greens meanwhile are busy with a leadership clash between their two co-leaders, Annalena Baerbock and Robert Habeck.

In France, it is unclear what happens after the presidency of Macron. Macron was a product of the French elites, but he has not yet built a credible legacy in terms of enacting policies or facilitating the emergence of credible successors. His controversial pension reform, which was approved through the Article 49.3, which allows the government to circumvent parliament, has not made him more popular. In 2027, a possible victory by Marine Le Pen is considered to be the central scenario. And Marine Le Pen has not yet built a credible profile as a good administrator of France’s domestic and international affairs. 

In Italy, prime minister Meloni is avoiding making huge mistakes, but the different weight Italy is considered to have on decision-making processes after the Mario Draghi’s era has been abundantly noted. Meloni herself believes that it is Macron who is keeping her out of the most relevant decision tables within European politics. At the same time, Italy’s difficulties in spending the money coming from the EU’s Recovery Fund is not helping to improve the country’s image in terms of its efficiency and effectiveness.

Especially at a time when the West is committed in a war against Russia, and indirectly against China (which is the champion of all existing and potential autocracies), it cannot afford to be presenting itself with such un-inspiring political leadership. The survival of democracy itself is at stake.

by Brunello Rosa

27 March 2023  

In the past few weeks many events have occurred that have made the world a more dangerous place. In mid-March, a MQ-9 Reaper reconnaissance drone collided with two Russian Su-27 fighter jets and fell into the Black Sea. This is the first official “military exchange” between Russian and NATO forces over the conflict in Ukraine; albeit an indirect one, as the drone was un-armed and the Russian jets did not aim to shoot it down. 

Subsequently, the state visit by Xi Jinping to Moscow made the “limitless cooperation” between China and Russia even stronger than it already was. And Xi can no longer credibly say that Putin misled him regarding his intentions on Ukraine. After one year of war, with dozens of thousands of deaths, it is perfectly clear what Putin’s intentions are, and it is also clear that Xi will not try to dissuade him from reaching his aims, at least not yet. (Apart from the fig leaf that is the purported “Chinese Peace Plan”). This comes after the International Criminal Court issued an arrest warrant against Putin for war crimes, in particular for the deportation of Ukrainian children to Russia. 

Russia has now started to use the Chinese yuan as its international reserve currency, in a sign of subjugation to its stronger ally. It is yet to be seen whether China will start openly selling weapons to Russia for its “special operation” in Ukraine. That would mark a definite escalation of the conflict, and its official transformation into a proxy war between the US and China. 

Finally, Russia has declared that it will deploy tactical nuclear weapons to Belarus, in an extreme attempt at dissuading NATO countries (chiefly the Baltics and Poland) from providing further military assistance to Ukraine. Putin has also said that NATO and his allies are now akin to the Nazi alliance that Russia fought during WWII, which in Russia was called the “Great Patriotic War.” NATO responded that Russia’s deployment of nuclear weapons to Belarus is “dangerous and irresponsible.” 

One could give further examples, but the story here is clear. The rhetoric coming from the two sides is hardening, instead of softening, and their actions are also escalating, in terms of NATO providing support to Ukraine and China helping Russia. Contemplating a nuclear attack in Ukraine has now become part of the central scenario, rather than a tail or even a risk scenario. It is understood that NATO would not react to a Russian nuclear attack with a nuclear response, but rather with a conventional retaliation of devastating proportions, to obliterate the Russian army in Ukraine, potentially including in Crimea.

World leaders seem to be sleepwalking into a nuclear Armageddon that could lead to World War 3. This is the reason why incidents such as the contact between the Russian jets and the US drone may be much more consequential than they could appear prima facie. One can imagine that in a situation of even higher tension between the two sides, a collision of this kind could easily be construed as the pretext for the beginning of direct military exchange between NATO and Russia, similar in nature to the killing of Archduke Ferdinand in Sarajevo, which of course marked the beginning of WWI. 

by Brunello Rosa

20 March 2023  

The ongoing banking crisis claimed more victims last week. The parent company of SVB filed for bankruptcy under chapter 11 rules in order to protect its assets from creditors. Meanwhile, Silvergate has gone under, and First Republic bank is also under stress. A group of 11 banks pooled resources to put together a rescue plan worth around $30 billion, in an attempt to stop the slide on the banks’ equity prices, which had collapsed by 90% from their peak of $219 reached at the end of 2021. It is not yet clear weather this rescue plan will be effective, as the fall in the banks’ equity prices has not yet stopped.

Much more significantly, on the other side of the Atlantic, one of the major European lenders, Credit Suisse, also got into trouble. Credit Suisse’s troubles started years ago, with very poor investment decisions, the most recent and insignificant of which have been the financing given to Greensill and to Archegos, both of which resulted in heavy losses for the bank.

Credit Suisse also had to apply for public rescue, with the Swiss National Bank providing emergency funds to it to the tune of €50 billion. During the weekend, the acquisition of Credit Suisse in its entirety by its historical rival, UBS will likely put an initial end to this story. Its investment bank operations, which were supposed to be shut down anyway, remain the most problematic part of the sale, as they may conceal hidden losses. 

The cases of SVB and Credit Suisse are very different. SVB had engaged in a very conservative business model, based on re-investing in safe US Treasury bonds; its collapse was caused by the lack of basic risk management practices. Credit Suisse meanwhile had engaged in a series of risky operations, the losses from which ultimately eroded the bank’s capital.

While this episode of financial instability was unfolding, central banks had to decide whether or not to continue their tightening cycles in order to a combat still-elevated inflation rate. As we discussed in our review, the European Central Bank decided to carry on with its pre-announced 50 basis point increase in interest rates, in part to address inflation but also to send a signal that the European banking system was solid and not involved in the ongoing banking crisis affecting US and Swiss banks. 

This week, it will be the US Federal Reserve and Bank of England’s turn to decide on their respective interest rates. As discussed in our previews, we expect both central banks to increase their policy rates by 25 basis points, unless new financial instability episodes emerge before their policy meetings take place.

But the genie is out on the box: it has become patently clear that a conflict exists between pursuing price stability and financial stability goals. We had discussed this at length in our 2023 Global Outlook, long before these episodes manifested themselves. During her press conference, Christine Lagarde attempted to provide assurances that such a conflict does not exist, as the ECB will use its interest rates primarily to fight inflation, and its liquidity tools to prevent financial instability from spreading. But the reality is likely to be much more difficult. 

Central banks may need to stop their tightening cycles, and perhaps even start cutting rates or resuming QE, to make sure that the financial system is not in danger. The next few weeks will show whether or not central banks will have to resort to these kinds of measures to prevent further financial instability episodes.

by Brunello Rosa

13 March 2023

At the end of last week, the Silicon Valley Bank (SVB) collapsed, just a few days after a much smaller lender, Silvergate, announced a plan to wind down its operations. The bank had USD 212bn in assets, a market valuation of around USD 16bn as recently as Wednesday last week, and a valuation of USD 44bn less than 18 months ago. At the end of December 2022, SVB had USD 173bn in deposits. However, on Thursday the bank suffered a USD 42bn withdrawal of deposits, after losing USD 1.8bn in a USD 21bn sale of part of its bond portfolio (made up of Treasuries and mortgage-backed securities). 

SVB tried to make a final, desperate attempt to shore up its capital by issuing USD 1.25bn of its common stock, plus USD 0.5bn of mandatory convertible preferred shares (which are slightly less dilutive to existing shareholders), while private equity (PE) firm General Atlantic had previously agreed to buy 0.5bn of SBV’s common stock in a separate private transaction. But this last attempt failed, and the bank was shut down by the Federal Deposit Insurance Corporation (FDIC), the US regulator that guarantees bank deposits of up to USD 250,000. Following that, the Bank of England put the UK arm of SVB into insolvency as well.

Why did the bank fail? Being exposed to crypto trading (Circle, the operator of one of the world’s largest stablecoins, said that USD 3.3bn of its reserves were held at SVB) and start-ups, including in the healthcare sector, one could think that the bank failed given the collapse in tech and crypto assets valuations over the last year. But the reality is much simpler, and to a certain extent is even more alarming. 

The business model of SVB was surprisingly “conservative”. The bank would receive large deposits from tech and crypto companies that had raised their funds through venture capitalists and PE firms. These deposits were reinvested into ultra-safe bonds – in particular Treasuries and mortgage-backed securities, both of them held in massive quantities by the Federal Reserve – and also foreign government bonds. As of the end of 2022, the bank had $26.1bn in available-for-sale securities and around $91bn of securities in a held-to-maturity portfolio. 

This business model would make money as long as policy interest rates were low, such that the cost of deposits would be minimal and the value of the bond portfolio would remain high. But as the Fed increased its policy rates by around 5% in one year, the cost of deposits rose from 0.14% to 2.33% in the same time-span, while the value of the bond portfolio declined. For this reason, the bank had reported a loss of USD 15bn at the end of last year. 

So, the bank didn’t fail because it had invested in assets that were too speculative, or followed a business model that was too risky. It collapsed because the most basic risk management practices were not followed. Banks tend to have a diversified depositor base, with a number of small – fully insured – depositors. They would not run at the first bad news. But the vast majority of SVB’s depositors were not insured, so they wanted their money out as soon as they perceived an increased default risk. Furthermore, banks would normally invests in floating rate notes, which gain in value if interest rates go up, or they would enter into swap agreements to insure against rising interest rates. This didn’t happen. 

So, why this is scary? We discussed how recently the New York Fed had defined an r** rate, a rate over which financial stability episodes could emerge. If r** was below the neutral interest rate, r*, or in any case if it was below the terminal rate, the central bank may be forced to stop its tightening cycle in order to prevent further episodes from emerging So, as Hyman Minsky predicted in his Financial Instability Hypothesis, downturns in financial markets occur when interest rates go up. SVB was a fragile bank, from a Minskian perspective, for the reasons exposed above. But other lenders may fall from similar difficulties if interest rates continue to increase at this speed. And all this is happening just days before the next FOMC meeting, in which the Fed may decide to ratchet up the pace of its tightening cycle again, by 50bps, in response to the positive news from the labour market and the stubbornly high inflation rate.  

by Brunello Rosa

27 February 2023  

On February 24th, 2023, the one-year anniversary of Russia’s invasion of Ukraine took place. As we discussed in various columns on this theme, this date also marks the end of the post-WW2 equilibria, the official end of this phase of the globalisation process, and an acceleration to the polarisation of the world between the spheres of influence of the US and China, as part of the broader Cold War 2 between the world’s super-powers. 

On February 4th, 2022, Russia’s President Vladimir Putin and China’s President Xi Jinping met in Beijing and issued a joint declaration that called for the beginning of a “limitless cooperation” between the two countries. That declaration, intended to be the first step toward the establishment of a new, multipolar world order, represented the de-facto green light given by China to the Russian invasion of Ukraine. 

Subsequently, press reports were released in which Xi expressed his irritation for not being fully informed by Putin about his intentions prior to the invasion. (Indeed, even Russia’s own Foreign Minister Sergei Lavrov said he was informed about Putin’s decision only after the invasion had started). But the reality is that the recent European tour by China’s plenipotentiary Wang Yi concluded in Moscow, with a meeting with Putin, and – according to press reports – Xi himself is expected to visit Putin soon. 

Whatever the recollection of events may be, the fact remains that the relationships between Russia and China remain “rock solid”, and now the world has polarised between the US and its allies, primarily in Europe (which has given up any dream of “strategic autonomy”) on the one hand, and China and its allies on the other. Only a bunch of countries can afford not to choose between these two sides and remain non-aligned; primarily, India. But India has joined China in not approving the UN resolution that condemns Russia’s invasion of Ukraine last week (141 voted in favour, 32 countries abstained - including India and China – and 7 voted against, i.e. Belarus, Nicaragua, Russia, Syria, North Korea, Eritrea and Mali.) 

In our view, many countries in Africa and Latin America will likely become battlefields of proxy wars between the US and China, as happened during the Cold War between the US and Soviet Union (and in fact, many of those same countries abstained in the UN resolution asking Russia to leave Ukraine). In our opinion, the war in Ukraine is already the first of these proxy wars between the US and China, fought by Ukraine and Russia, notwithstanding the ongoing rivalry between these two countries, which of course dates back a long time before Cold War 2 clearly emerged. 

And precisely because this is already a proxy war between US and China, we believe that China’s 12-point peace plan (“position paper”) to achieve a political solution to the Ukrainian crisis is destined to fail. The US will never accept that its main contender will become the peacemaker in a conflict in which the US is so largely invested. 

Considering all this, it is hard to be optimistic about the duration and intensity of this war. What could be considered a “natural equilibrium” for Putin (a result after which he could claim full victory), i.e. the occupation – besides Crimea – of the four “annexed provinces” such as Luhansk and Donetsk, plus Odessa’s region up to Transnistria in Moldova, is totally unacceptable for the international community, and certainly to Ukraine. It would be hard enough to convince Ukrainian president Volodymir Zelensky to give up Crimea as part of a broader peace plan, and for Putin merely stabilising the position of Crimea alone after such a costly war would be considered a severe defeat. 

This means that a diplomatic solution to this conflict is not in sight; but a victory of either of the two sides on the ground is also very unlikely, as US generals have admitted. The conflict will therefore continue, along with its dire humanitarian, social, economic and financial consequences. And with the risk of a nuclear escalation having in fact increased, rather than decreased, in recent weeks, as testified by Russia’s decision to suspend the application of the NEW START treaty on nuclear non-proliferation). The international community will need to continue working hard to find any solution that avoids such a catastrophic eventuality.

by Brunello Rosa

20 February 2023  

In a column a few weeks ago, we asked ourselves whether China was ready to make a broader U-turn after the massive change of direction it had taken regarding its Zero-Covid policy. A symbol of that potential change was the arrival of Qin Gang, a former ambassador to Washington, as foreign minister, replacing Wang Yi. We also mentioned how Xi Jinping himself had started to make speeches in favour of private initiatives, after years of carrying out witch-hunts against the private sector, in particular the tech sector. 

Now things seem to have moved further in that direction. Wang  ascended to the Politburo after the October Congress of the CPP that confirmed Xi as party leader for the third time, and has replaced Yang Jiechi as the Director of Central Foreign Affairs Commission, the highest diplomatic position in China. Wang has recently started a “charm offensive” in Europe, beginning from Paris where he met French President Macron ahead of the Munich security conference. The messages that Wang is trying to pass to his European counterparts are twofold: 1) that China is open for business; and that 2) China is willing to find a diplomatic solution to the war in Ukraine. 

Regarding the first point, this seems almost a foregone conclusion. China has observed an acceleration in the process of global polarisation and a separation from the US and, to a lesser extent, from European countries, a process which is clearly premature. China is rightly betting on the growth of South-East Asia and Africa in the next 20-30 years, and believes that the countries from these regions of the global economy will eventually replace the US and Europe as China’s largest “customers” (i.e. importers of its products). That is the reason why the vast majority of the signatories of the BRI are from these two regions of the global economy. But these countries are not large enough to replace Europe and the US just yet and – crucially – they do not possess the technology that the EU and US are able to provide to China, in terms of materials, semi-conductors, etc. 

On the second point (namely, finding a diplomatic solution to the war in Ukraine), facts tell a different story than words or intentions. Recent press reports from the Wall Street Journal and other US newspapers show that trade between China and Russia has massively increased since the beginning of the war in Ukraine, both in terms of commodities and manufactured goods and in terms of technology that can be used for civilian and military purposes. Between March and September 2022, trade between the two countries has grown by USD 27bn, and touched USD 100bn. Russia has become even more dependent on Chinese imports, which now represent 36% of Russia’s total. More generally, Russian trade with China has allowed it to cicumvent the tech embargo imposed by the US, and its purchases of foreign-made semi-conductors has increased by 34% in 2022, with the lion’s share coming from China.

On the back of these considerations, the following preliminary conclusions may be drawn. First, it is extremely positive that China has realised how damaging for its own reputation and economic activity some of its policies have been, including the Zero-Covid policy and the support to Russia for the war in Ukraine. Secondly, building on this realisation, and considering its purported intention to change tack, China now needs to show actions that are consistent with its words. Thirdly, even in the most favourable scenario, in which China manages to at least marginally re-orient its policy choices, we remain convinced that a Cold War between the US and China is ongoing, and will develop further in coming decades. But its intensity and speed do matter a lot for the well-being of the global economy and the geopolitical environment. So, any softening on this front will always be welcome. 

by Brunello Rosa

6 February 2023  

A number of major central banks held their policy meetings last week, to decide what course of action to take for the beginning of the year. 2023 was widely expected to be a year of recession for a number of countries. At the beginning of January, the head of the IMF Kristalina Georgieva said that the IMF expected one third of the global economy to be in a recession during the year. 

Subsequently, the IMF released the January update of its World Economic Outlook, initially released in October 2022, titled “Inflation Peaking Amid Low Growth”. In effect, the January update showed an upward revision to the growth forecasts made for a number of countries, and for the global economy as a whole. 

Meanwhile, inflation seems to have peaked in some key economies, such as the US (where inflation decreased from 9.1% in June 2022 to 6.5% recently), the Eurozone (from 10.6% in October 2022 to 8.5%), the UK (from 11.1% in October 2022, to 10.5%) and Canada (from 8.1% in June 2022, to 6.3%). 

So, this year of stagflation, as we described in our 2023 outlook, appears to be a bit milder than initially anticipated, with slightly higher growth and slightly lower inflation. Still, one needs to remain vigilant about some ongoing risks, for example that of a new Russian offensive in Ukraine, which could bring the global economy to a standstill once again. 

How have central banks reacted to this updated macroeconomic environment? The Bank of Canada was the first to announce the outcome of its policy meeting at the end of January. The Bank increased its policy rate by 25bps to 4.5%, while continuing its Quantitative Tightening program. But, most importantly, it announced that “[the] Governing Council expects to hold the policy rate at its current level while it assesses the impact of the cumulative interest rate increases”. In a nutshell, it announced a pause in its tightening cycle.

Last week, it was the turn of the Federal Reserve, the Bank of England and the European Central Bank to decide upon their own courses of action. The Fed announced another 25bps increase of its target range, to 4.5-4.75%, and two more rate increases in March and May. As discussed in our in-depth review, during the press conference Chair Jay Powell sounded as hawkish as one can be given the circumstances, saying that the dis-inflation period has just begun and that there is still “a long way to go,” among other messages. The market totally disregarded the hawkish components of Powell’s press release, and celebrated the fact that the end of the tightening cycle is finally in sight. Funnily enough, the market had disregarded the same message for months; it had ignored the message that the peak of the cycle was in fact near, focusing instead only on the further rate increases and the rise in the terminal rate expected by the Fed. 

A similar fate occurred for the ECB, which increased its deposit rate by 50bps to 2.50% and announced another 50bps hike in March, while further specifying the criteria for its QT starting in March. Lagarde also said that there is still ground to cover and that further hikes are likely after March. But the market celebrated the statement in which the ECB says that, after March, it will “evaluate the subsequent path of its monetary policy”, as this future re-evaluation was already the end of the tightening cycle. 

The Bank of England chose an approach similar to the Bank of Canada’s. It raised its repo rate by 50bps to 4.0%, but then indicated what seems to be a likely pause for the months ahead, without making further mentions of the QT program. Again, this generated euphoria in the market. 

To conclude, it seems that the macroeconomic outlook is less malign than initially anticipated, and central banks are announcing a pause, or signalling an imminent end of, their tightening cycles. This clearly makes market participants very happy. Hopefully bad news will not intervene too soon to interrupt this moment of relief.

by Brunello Rosa

30 January 2023  

We have discussed on several occasions that we believe there is an ongoing Cold War between the US and China, which is being fought on the fields of trade, technology, and supply chains. For example, on the tech side, the Netherlands and Japan have recently joined the US in restricting chip exports to China. According to Harvard scholar Graham Allison, there may be a chance that this Cold War will escalate into a “hot war”, with an open military exchange between the US and China taking place. In our in-depth analysis of Nancy Pelosi’s visit to Taiwan, we also discussed how Taiwan may become the detonator of such a military exchange. 

Today, the news emerged of a memo written by General Mike Minihan, head of US Air Mobility Command, in which the general said that he has a gut feeling that “the two military powers were likely to end up at war” by 2025, according to the FT. In fact, in 2024 there will be the US presidential election, which will distract the US administration and population. There will be also presidential elections in Taiwan. The uncertainty created by these two occurrences may favour a Chinese attempt to take over Taiwan. 

The US had historically kept so-called “strategic ambiguity” as to whether they will intervene in defence of Taiwan, but recently Biden has been more vocal about the fact that the US will in fact intervene. This is supposed to deter China from taking that step. That is the reason why China is watching very closely the US position vis-à-vis the war in Ukraine. In the joint declaration of 4thFebruary 2022 between Chinese President Xi and Russian President Putin, the “Russian side reaffirm[ed] its support for the One-China principle, confirm[ed] that Taiwan is an inalienable part of China, and oppose[d] any forms of independence of Taiwan.”

So, how is the situation progressing in Ukraine? Last week, we discussed the hesitation by Germany in sending its Leopard 2 tanks to Ukraine. Eventually, the German Chancellor decided to send 14 tanks, and allow other European countries to do so. Also, the US approved another aid package for Ukraine, which includes the possibility of sending 31 M1 Abram tanks. The US and Germany are the two largest providers of weapons to Ukraine, followed by the UK. Meanwhile, Lockheed Martin said it is ready to provide F-16 fighter jets to Ukraine, if necessary. 

On the back of this news, the FT wondered if Ukraine was getting ready to resist the likely assault by the Russian troops that is expected to take place in the spring. Or rather, whether Ukraine is ready to launch its own offensive. Italian defence minister Guido Crosetto said that, if Russian tanks come back to Kyiv, World War 3 would ensue. That cannot be taken for granted. But clearly a direct military exchange between US and China over Taiwan would likely lead to what will undoubtedly be labelled by future historians as the beginning of World War 3. 

Is this scenario avoidable? In theory, yes, even if it seems to be that we are sleepwalking into it. On the positive side, after Pelosi’s provocatory trip to Taiwan, there is the scheduled trip of US secretary of state Antony Blinken to China in a week’s time; Blinken will be the first cabinet secretary from President Joe Biden’s administration to visit China. 

Additionally, President Xi will visit the US in November for the APEC meeting, which will be held in San Francisco. One hopes that these will be occasions for the two super-powers to clarify their respective positions and re-start a constructive dialogue, instead of being occasions on which ultimatums are launched. 

by Brunello Rosa

23 January 2023  

A few weeks ago, we discussed how the geopolitical landscape was in flux, with the re-organisation of international alliances and a new world order emerging as a result of the war in Ukraine. In particular, with Russia siding with China in a Cold War II between the US and China, a polarisation of the world has emerged. 

As part of this broader re-arrangement of the world order, we discussed how a new gathering of seven countries, formed around the BRICS group, emerged; we labelled this the EM G7. Besides China, Russia, India, Brazil and South Africa, two additional countries were invited as observers. One is Saudi Arabia, with which China has just formed a new strategic partnership, as we discussed in our recent column. 

The other country is Argentina. As discussed in our recent in-depth analysis of the country, Argentina is undergoing a difficult macroeconomic period, characterised by slow growth, high inflation and high interest rates, with political turmoil on the horizon given the presidential election occurring at the end of the year. 

As we said, the main reason to have Argentina in the group is because Argentina has recently joined China’s Belt and Road Initiative (BRI). With Argentina in the BRI and Brazil in the BRICS, China has extended its influence over the entire Latin American region, through its two largest countries. Among others, Chile and Peru are also part of the BRI, giving China influence over the entire west coast of South America. 

Now Brazil and Argentina have announced that they intend to enter a currency union, by creating an additional currency that would run in parallel to the Brazilian real and the Argentinian peso. According to estimates by the Financial Times, this would be the second largest currency union (representing around 5% of the world GDP) after the Euro (14% of the world’s GDP), and ahead of the France’s inspired CFA franc, which is shared by several African countries and is pegged to the euro. The new currency would be yet another attempt by countries that are not totally aligned with the US to reduce their dependence on the US dollar.

All of the factors above suggest that the polarisation of the world continues and was accelerated by the war in Ukraine. Some countries are backtracking from their previously held positions. As we discussed last week, China is shifting from some of its recent positions, first on the zero-Covid policy, then on distancing itself somewhat from some of the most extreme positions of Russia, and finally on re-opening a dialogue with the private sector, after the witch-hunting of the country’s tech companies and private-led education that took place during the last couple of years.

On the other side of the equation, Germany has announced that before sending more of its Leopard tanks to Ukraine, it will want to run a full analysis of its inventory. This is a way of buying time and sending a signal to Russia that it does not want to espouse the most extreme position of NATO countries. So, while China puts some distance between itself and Russia, Germany gets a bit closer to Russia, or at least reduces its distance.  

These are all proofs that the geopolitical environment is in flux, but is solidifying towards a polarisation of the world, symbolised by the ongoing Cold War II between the US and China.

by Brunello Rosa

16 January 2023  

Last week we discussed how authoritarian or populist leaders are on the rise in various parts of the world. A possible precursor to this phenomenon has been the emergence of Chinese President Xi Jinping. In 2018 Xi changed the country’s constitution to allow the President to remain in power for life, instead of stepping down after 10 years like his predecessors Hu Jintao and Jiang Zemin. Last October, he was elected leader of the Chinese Communist Party (CCP) for the third time in a row, something his predecessors did not dare to do. 

When elected leader, Xi changed the composition of the Politburo and of its Standing Committee, replenishing it with party members loyal to him who would not challenge his views or, most importantly, his policies. This move was clearly intended as a method of consolidating power in his hands. 

This was happening at the same time that China was forging its “limitless cooperation” – i.e. strategic alliance – with Russia, another state whose leader, Vladimir Putin, had also changed the constitution to allow himself to remain in power potentially until 2036. Russia was conducting its unjustified invasion of Ukraine, with China supporting (perhaps reluctantly) the “special military operation”, possibly in order to establish a precedent in case of a future invasion of Taiwan. 

Just when all the power seemed consolidated in Xi’s hands, the inevitable happened: protests emerged against the ruthlessness of the Xi-mandated Zero-Covid Policy (as we discussed in our preview columns). These protests, for the first time, were not simply against local leaders, as has happened in the past. They were also against the CCP, and its leader as well. 

Xi’s foreign minister, Qin Gang, a former Chinese ambassador in Washington, may be the expression of this potential rethinking of the overt confrontation of China with the West. If there were to be a rapprochement between the US and China, potentially sealed at the APEC meeting in San Francisco this coming November, when Xi is expected to visit the US, it would be welcome news.

The Politburo has since allowed cities to ease the Covid restrictions, in a move that was intended to be a soft, and less visible, U-turn in policy. Official data from China now admit there have been 60,000 deaths as a result of the re-opening of the economy and the consequent re-spreading of the virus, at a time when China still has not vaccinated large part of the population. Many countries introduced restrictions for Chinese travellers, against which the Chinese government threatened “retaliation” – without considering the severe and unilateral quarantine measures the government itself has been imposing on foreign travellers for the last two years. 

Meanwhile, the FT reported that doubts have emerged about China’s “limitless cooperation” with Russia. In a previous column, we have already talked about the first cracks emerging. But now it seems that irritation is mounting in Beijing on the way Putin is conducting Russia’s military campaign in Ukraine, which is causing severe damage to the global economy, including for China, which depends on foreign growth for its exports. Additionally, it seems that on the famous meeting between Xi and Putin on 4th February 2022, Putin hid his invasion plans from Xi, only saying Russia “would not rule out taking whatever measures possible if eastern Ukrainian separatists attack Russian territory and cause humanitarian disasters.” 

Our fear however is that any such rapprochement may be merely a tactical move, to ease the tension on Xi’s leadership and on the global economy. The broader context of Cold War II seems to us to still be intact, and likely to remain in place for the foreseeable future.

by Brunello Rosa

09 January 2023  

The supporters of former Brazilian President Jair Bolsonaro assaulted and occupied the Brazilian parliament and other federal institutional buildings at the end of last week, to protest against the election of Ignazio Lula da Silva as the new President of Brazil (his third mandate). This episode is closely reminiscent of Trump’s supporters’ assault on Capitol Hill in January 2021, on the occasion of the election of Joe Biden to the presidency of the US. As we discussed in numerous articles, Bolsonaro was widely seen as a leader that would have transformed Brazil into yet another autocracy, had he been re-elected. 

Meanwhile, in Israel, Benjamin Netanyahu was re-elected as Prime Minister of the country, following the short parenthesis of Naftali Bennet and Yair Lapid. Netanyahu has formed a government that is widely regarded as the most right-wing in Israeli history. The new government has proposed a reform of the judiciary, which will give the government a say in the appointment of judges. The political and civil society opposition has labelled the move as the “end of democracy” in the country. 

In Italy, the September 25th general election resulted in the appointment of Giorgia Meloni, leader of the right-wing party Brothers of Italy, as Prime Minister. As we discussed in our recent trip report, Meloni has adopted a moderate approach, but some of the choices of her government confirms the radical right-wing approach of her coalition. Additionally, she still has not changed the symbol of her party, which contains the flame emanating from Benito Mussolini’s grave. 

Also in Rome, but on the other side of the Tiber river, the death of the ultra-conservative former pope Joseph Ratzinger has led the orthodox component of the curia to making an attack on the progressive Pope Francis, who is seen as too open vis a vis the issues of modern society. Ratzinger’s presence was keeping this conservative fringe component at bay, as he did not want to be perceived as an anti-pope. But now the war for the succession of Francis has begun, and it is very unlikely that another equally progressive pope will be elected. 

In France, as we discussed in our recent trip report, the election of right-wing Marine Le Pen in 2027 is now considered a central scenario rather than a risk scenario. Marine Le Pen could stage “a Meloni” and pretend to moderate and move to the centre for some time, but her radical positions, especially on immigration and civil rights, would likely emerge before long. Also, she may heavily impact the EU integration process, in a way that Italy will never be able to. 

These are only recent examples of a much larger swing that is occurring at the global level, in which right-wing movements are coming to power. In other cases, populist leaders, of the right and the left, are being voted in. Especially in Latin America, populist leaders from the left are contributing to the so-called “Pink Tide”. This goes hand in hand with a broader phenomenon, whereby even democratically elected leaders are becoming autocratic or nationalistic leaders, such as in Turkey and in India. We have discussed in our previous columns this tendency of autocratic leaders to emerge in the last few years. 

All these phenomena are contributing to the even broader trend of the decline of liberal democracies in favour of electoral autocracies, as testified by the studies of the V-Dem project and several academic papers. 

by Brunello Rosa

03 January 2023  

Last week, we discussed how 2023 will be a year of stagflation from a macroeconomic perspective. We discussed how the global slowdown, which will translate in outright recessions in several countries (a third of the global economy, according to the IMF) will be accompanied by still-high inflation. Inflation may fall for cyclical reasons (including the fall in energy prices recorded in the last few months), but will remain sticky and elevated for a series of structural reasons discussed in our 2023 Global Outlook and mentioned in our latest column. This week, we discuss the implications of this macroeconomic outlook for policy and markets. Regarding policy, we discuss fiscal and monetary policy in turn. 

Fiscal policies will be inflationary in the next few years, including 2023, as governments will have to fight “wars” on at least five fronts. 1) Hot and cold wars lead to larger budget deficits that are eventually monetized and tend to cause higher inflation. 2) The war against global climate change will be very expensive as countries transitions to new form of energy consumption. 3) The war to prevent the next global pandemic will be very expensive ex ante or ex-post if we don’t prevent it and end up with another costly Covid-style pandemic. 4) The war to prevent social strife in face of rising inequality will be expensive as social spending, transfers and lower taxes for workers and left-behind households. 5) The tech war in which AI, robotics and automation will lead to job losses that require stronger social safety nets for those experiencing permanent tech or trade-related unemployment. 

All these five “wars” over the next decade will lead to greater public spending, transfer and lower taxes for the those “left behind”, while the ability to raise taxes is constrained by politics and economics. Thus, higher budget deficits that will crowd out growth if financed with debt; and the eventual monetization of such deficits as a “debt trap” will force central banks to wimp out and blink.

Regarding monetary policy, with inflation much more persistent than central banks currently expect in 2023, central banks will have to either hike much more than they currently signal, thus triggering a more severe hard landing and financial markets distress; or they will need to blink and wimp out, in which case inflation expectations get de-anchored, price-wage spirals ensue and higher inflation persists. We believe that central banks will be pressured to stop tightening or even easing if there is a hard landing; and in presence of negative supply shocks and a wage-price spiral even a hard landing may not push inflation low enough towards target. 

So monetary policy and fiscal policy risk being inconsistent one another, and this will cause plenty of headaches to policymakers. Additionally, central banks will face a dilemma of countering price instability (with higher rates) or financial instability (potentially, by continuing or resuming asset purchases). 

What are the implications for markets? In our global outlook we discuss several scenarios, depending on how the macroeconomy and policy evolve. In a nutshell, in our baseline we expect equity prices to continue their descent, as inflation proves stickier than expected, and central banks are forced to keep rates high for longer. As a result, we also expect higher short- and long-term rates in all major jurisdictions. In the currency space, we expect the USD to weaken against its major currencies as their central banks catch up with the Fed in terms of policy tightening. As inflation remains elevated, and interest rates high, we expect alternative investments (private equity, crypto, real estate) to continue suffering. On the other hand, we expect digital infrastructure investments to continue doing well in coming years.

by Brunello Rosa

28 December 2022

2022 was a year of rising inflation and slowing economic growth; it was a year in which the conventional wisdom of central banks, sell-side research, and consensual forecasts turned out to be mostly wrong about key economic, policy and market views. In particular, consensus forecasts got the inflation outlook wrong: the rise in inflation proved to be persistent and permanent, rather than transitory and temporary. 

The consensus view was also that the rise in inflation was mostly driven by excessively loose monetary, fiscal and credit policies. But, in addition to these bad policies there was also plain bad luck, with a series of negative aggregate supply shocks taking place. These included the initial impact of Covid-19 on the supply of goods and services, and on the supply of labor and global supply chains; the impacts of the Russian invasion of Ukraine regarding energy and other commodities prices; and the impact of the continuation – until recently – of China’s Zero Covid Policy on global supply chains. 

Another opinion held by the consensus was that central banks, as they were phasing out QE and credit easing and raising policy rates, would be able to achieve a “soft landing”: a fall in inflation to the 2% target without a recession or rise in the unemployment rate. That turned out to be incorrect, as now the UK and Eurozone economies are already entering into a recession, and even the Fed expects that a soft landing will be “very challenging”, and thus expects a “softish” landing and some serious “pain”. 

Now the new conventional wisdom is that we will experience a “short and shallow” recession (rather than a severe one) that will trigger a sharp drop of inflation and allow central banks to ease by H2 of 2023. The consensus also argues that – consistent with such a mild recession – central banks will remain committed to achieving their 2% inflation target. We continue to have views different from the consensus in these last two debates, after having been correct in the previous debates of 2021-22. 

We believe that a hard landing is more likely than a short and shallow recession. Why? First, we argue that although inflation has peaked in most advanced economies, and has started to fall, it will nevertheless remain more sticky than central banks and consensus opinion expects, and thus central banks will be forced to hike more than currently predicted, if they want to push inflation closer to target. 

The argument for stickier inflation is based on several points: the war in Ukraine will continue and get uglier, rather than be resolved; the supply bottlenecks in China will remain in spite of the phase out of Zero-Covid Policy, as China will continue its stop-and-go policies towards Covid and a full phase out of the policy will lead to a spike in cases and reduce the available labor supply of healthy workers; even if stronger growth were to resume in China – not our baseline scenario – its impact on commodities demand and prices would be sharper. Commodities prices have declined in the last few months in spite of their spike during H1, mostly because of expectations of lower demand – given the expected global economic contraction – rather than because of much higher supply. Next year commodity prices – and not just in energy – are likely to spike, as many years of under-investment in new capacity will lead to a shortfall in supply, even if demand falls as well. 

Secondly, geopolitical factors will continue weighing on economic activity. The war in Ukraine will continue for much longer than people expect. One cannot rule out a military strike by Israel against Iran – that is effectively now a threshold nuclear star – that would lead to a dramatic spike in energy prices. An outright confrontation (not our baseline scenario now) between US and China over Taiwan – where 50% of all computer chips and 80% of high end chips are produced – would be another massive stagflationary shock.

by Brunello Rosa

03 January 2023  

Last week, we discussed how 2023 will be a year of stagflation from a macroeconomic perspective. We discussed how the global slowdown, which will translate in outright recessions in several countries (a third of the global economy, according to the IMF) will be accompanied by still-high inflation. Inflation may fall for cyclical reasons (including the fall in energy prices recorded in the last few months), but will remain sticky and elevated for a series of structural reasons discussed in our 2023 Global Outlook and mentioned in our latest column. This week, we discuss the implications of this macroeconomic outlook for policy and markets. Regarding policy, we discuss fiscal and monetary policy in turn. 

Fiscal policies will be inflationary in the next few years, including 2023, as governments will have to fight “wars” on at least five fronts. 1) Hot and cold wars lead to larger budget deficits that are eventually monetized and tend to cause higher inflation. 2) The war against global climate change will be very expensive as countries transitions to new form of energy consumption. 3) The war to prevent the next global pandemic will be very expensive ex ante or ex-post if we don’t prevent it and end up with another costly Covid-style pandemic. 4) The war to prevent social strife in face of rising inequality will be expensive as social spending, transfers and lower taxes for workers and left-behind households. 5) The tech war in which AI, robotics and automation will lead to job losses that require stronger social safety nets for those experiencing permanent tech or trade-related unemployment. 

All these five “wars” over the next decade will lead to greater public spending, transfer and lower taxes for the those “left behind”, while the ability to raise taxes is constrained by politics and economics. Thus, higher budget deficits that will crowd out growth if financed with debt; and the eventual monetization of such deficits as a “debt trap” will force central banks to wimp out and blink.

Regarding monetary policy, with inflation much more persistent than central banks currently expect in 2023, central banks will have to either hike much more than they currently signal, thus triggering a more severe hard landing and financial markets distress; or they will need to blink and wimp out, in which case inflation expectations get de-anchored, price-wage spirals ensue and higher inflation persists. We believe that central banks will be pressured to stop tightening or even easing if there is a hard landing; and in presence of negative supply shocks and a wage-price spiral even a hard landing may not push inflation low enough towards target. 

So monetary policy and fiscal policy risk being inconsistent one another, and this will cause plenty of headaches to policymakers. Additionally, central banks will face a dilemma of countering price instability (with higher rates) or financial instability (potentially, by continuing or resuming asset purchases). 

What are the implications for markets? In our global outlook we discuss several scenarios, depending on how the macroeconomy and policy evolve. In a nutshell, in our baseline we expect equity prices to continue their descent, as inflation proves stickier than expected, and central banks are forced to keep rates high for longer. As a result, we also expect higher short- and long-term rates in all major jurisdictions. In the currency space, we expect the USD to weaken against its major currencies as their central banks catch up with the Fed in terms of policy tightening. As inflation remains elevated, and interest rates high, we expect alternative investments (private equity, crypto, real estate) to continue suffering. On the other hand, we expect digital infrastructure investments to continue doing well in coming years.

by Brunello Rosa

19 December 2022

The global economy is clearly decelerating, as certified by the latest IMF forecasts, while inflation seems on the verge of peaking as energy prices have fallen in recent months. The world remains gripped by the stagflationary shock that has been caused by the pandemic and then by the war in Ukraine. But the effects of the numerous interest rate increases carried out by several central banks around the world is starting to be felt. Most economies are showing signs of deceleration, and inflation has started to turn in some countries, notably in the US. It seems also to be on the verge of peaking in other economies, such as in the Eurozone and the UK. 

Last week, there was a slew of central bank decisions that were made (which we discussed in our numerous previous and reviews) to take stock of these developments and adjust policy stances accordingly. To focus our discussion on just the major central banks, on Wednesday last week the Fed increased its Fed funds rate by 50bps, thereby reducing the pace of tightening compared to the 75bps rate hikes that had been introduced in previous FOMC meetings. On the other hand, the Fed has also increased its estimate of the terminal Fed funds rate again, something it has repeatedly done in the past. The market was expecting this pivot, but perhaps it was less significant than expected. 

On Thursday, the Bank of England (BOE) also delivered a 50bps hike, lower than the 75bps hike in November. This also came on the back of a slight deceleration of inflation, but in particular at the beginning of the recession that the BOE estimates to last a couple of years. 

Also on Thursday, the ECB raised its benchmark rates by 50bps, again lowering the pace from the previous 75bps. But at the same time it announced the beginning of its QT plan. This has sent shockwaves to the market, leading to a widening of intra-EMU spreads, particularly for Italy. Norges Bank, which in September 2021 was the first G10 central bank to start increasing rates in this policy cycle, increased its policy rate by 25bps, and announced that at least one further hike may be needed in 2023. To finish the day, the Swiss National Bank also increased its policy rate by 50bps,again lower than the 75bps decided upon in September. For the record, the SNB was the central bank with the lowest policy interest rate in the world (-0.75%) for a number of years, amid the deflationary fears led by the strong franc. 

All these actions show that central banks have now made a lot of progress in normalising their policy stances, and are moving into restrictive territory with a more cautious approach. They are doing this to make sure that their policy tightening does not transform what may be a relatively short and shallow recession into a prolonged and deeper contraction. 

The MPC was split in the decision, with some members voting for an unchanged rate, and another member voting for a larger rate increase. The BOE decisions are complementing those made by Sunak and Hunt in fiscal policy, which is expected to be highly restrictive in coming months. 

by Brunello Rosa

12 December 2022

Last week, during a three-day state visit to the Kingdom of Saudi Arabia, Chinese President Xi Jinping and Saudi Arabia’s de-facto ruler Mohammed Bin Salman (MBS) signed a Comprehensive Strategic Partnership Agreement (CSPA), in which the two countries are committing to support each other’s “core interests, sovereignty and territorial integrity, and to defend the principle of non-interference in the internal affairs of states.”

The CSPA is comprised of 35 memorandums of understanding, including deals worth USD 30 billion. It foresees cooperation between the two countries in the following areas: the automotive industry, supply chains, logistics, water desalination, infrastructure, manufacturing, mining, the financial sector, communications and artificial intelligence, and digital and space economies and technologies. China and Saudi Arabia stressed the importance of stability in oil markets, and “agreed to explore common investment opportunities in petrochemicals, and to enhance cooperation in solar, wind, and other sources of renewable energy.” They also agreed to cooperate on hydrocarbons, energy efficiency, and localization of energy sector components and supply chains, in addition to the peaceful uses of nuclear energy.

Besides these specific areas of cooperation, China and Saudi Arabia welcomed the signing of a “harmonization plan” between the Kingdom’s Vision 2030 social reform and economic diversification agenda and China’s Belt and Road Initiative, making use of the Kingdom’s location as a regional center.

In a recent report, we discussed how India was sitting on the fence in its decision to join either the Western camp led by the US, or a China-led camp. We also said that India would be eventually be forced to choose, and that even Brazil would have a hard time remaining in the list of non-aligned countries. In a press conference at the conclusion of Xi’s visit, Prince Faisal bin Farhan, the Saudi minister of foreign affairs, said that the deepening of relations between Saudi Arabia and China did not mean the Kingdom was turning its back on the US and other Western allies. But the impression we are left with is exactly the opposite. 

We also discussed how a new EM-G7 was emerging around the BRICS grouping, expanded to include Saudi Arabia and Argentina. With the signing of this CSPA between China and Saudi Arabia, another important step has been made towards the creation of this grouping of countries as an alternative to the G7. It includes some of the largest, fastest growing, or most resource-rich economies in the world. 

In a world in which the Americans say to their potential allies “you are either with me or against me”, this CSPA must be read as a slap in the face from Saudi Arabia to the US, irrespective of the reassurances given by the Kingdom’s foreign secretary. With its vast oil reserves, Saudi Arabia represents a key ally to have during Cold War II, and it seems that Saudi Arabia has decided to side with China at the moment, and be less close to the US. The harmonization between two landmark reform plans such as China’s BRI and the Kingdom’s Vision 2030 clearly signals that this is not just a tactical, trade-based agreement, but rather – as the title says – the beginning of a strategic partnership. 

This CSPA seems to be less far reaching than the “limitless cooperation” between China and Russia that was declared in Beijing on February 4th 2022. But it still represents good news for China and its allies, and bad news for the US and American allies. 

by Brunello Rosa

5 December 2022

In the last few days, news about protests taking place in China were widely reported by media outlets in both the Western world and in China itself. The focal point was the civil unrest that occurred in the city of Urumqi following an apartment fire that killed 10 people, who apparently could not escape the building they were trapped in because of the Covid-related restrictions. 

Various forms of civil unrest erupted nationwide, with protesters clearly criticizing the national government, the Communist Party, and its leader, Xi Jinping. This is a novelty for China, where protests have taken place in recent years but have targeted local leaders for their lack of action or mistakes made over local issues, such as environmental or transportation disasters. Not since the Tiananmen square protests of April-June 1989 has the authority of the Chinese Communist Party (CCP) been  directly challenged. On that occasion, the repression was ferocious, resulting in a massacre of the protesters.

The lesson from Tiananmen was that the CPP can repress any form of protest. But the CPP learnt a lesson as well, namely that it cannot govern indefinitely without popular support. For this reason, media outlets are now saying that the CPP is allowing various Chinese cities to ease the Covid-related restrictions. 

This does not represent a fundamental change in the official zero-Covid policy just yet, as Xi himself championed the policy and cannot lose face by carrying out an explicit U-turn. However, it is an important shift towards pursuing zero-deaths, rather than zero cases, which was a totally unrealistic objective in a country with relatively low vaccination rates among the elderly and a vaccine – the Sinovac – that is not as effective as those developed by Western countries. 

China should admit its failure in achieving this goal and start purchasing vaccines from the West, in particular those based on m-RNA technology that China has not yet developed. But in the context of Cold War II, this is clearly not possible, so it will still take time before China will fully re-open and the global economy can finally start breathing again. In fact, the global economy and financial markets will not be able to fully recover until China fully re-opens, resolving once and for all the supply bottlenecks that have plagued global value chains for the last three years.

What are the lessons from this entire story? First, that even in the most autocratic regimes, governments still need the explicit or implicit approval of their populations. History teaches us that autocratic regimes seem very stable until they collapse. Second, that even the most autocratic regimes cannot refuse to respond to their people’s needs. But here is where things may subtly start going wrong. 

In their joint declaration of February 4th 2022, on the sidelines of the Beijing Winter Olympics, Russian President Putin and Chinese President Xi said: “democracy is a universal human value, rather than a privilege of a limited number of States, and that its promotion and protection is a common responsibility of the entire world community.” As we discussed in our column of June 6th, this is clearly an attempt by Russia and China to re-define what democracy is. 

According to these autocratic leaders, democracy should not be intended as the electoral process by which people vote in their preferred leaders. Rather it should be the process by which governments, whether they are chosen via free elections or not, provide public goods to their people and keep them content. The number of democratic countries in the world is already dwindling. If this new concept of democracy takes place, dark days await us in the years ahead. 

by Brunello Rosa

28 November 2022

At the end of October, the presidential election in Brazil saw the narrow victory of Luiz Inácio Lula da Silva over the incumbent president Jair Bolsonaro. In so many respects, Lula was considered to be the antithesis if Bolsonaro, but last week the news emerged that there may be an element of continuity between the two leaders. President Lula announced that although Brazil continues to condemn Russia’s invasion of Ukraine, it does not intend to apply the sanctions that the West has activated against Putin’s regime. 

The reasons behind this choice are fundamentally economic, but possibly also geo-strategic. From an economic perspective, Russia and Brazil share cooperation in key sectors such as space and military technology, and telecommunication. For example, in 2012, after a state visit by Brazilian President Dilma Rousseff to Russia, Brazil signed an agreement to buy Russian anti-aircraft systems. At the same time, the state-owned Russian Technologies State Corporation (Rostec) and the Brazilian Odebrecht Defence and Technology signed a memorandum on technical cooperation, committing to the establishment of a joint venture for production of helicopters, air defence weapons, and naval vehicles. 

Additionally, Brazil is of the main suppliers of commodities to China, including but not exclusively in agriculture, and China in turn has been one of the main allies of Russia during this period of Russia’s international isolation, since its invasion of Ukraine. In November, the Chinese authorities updated their list of approved Brazilian corn exporters, making it easier for Brazil to export its corn to China, at a time when China’s imports from the US and Ukraine have been disrupted by geopolitical tensions. 

But, from a geo-strategic perspective, Brazil may be willing to follow the path of India. As discussed in depth in our recent report, India has so far decided not to choose between US and China in the dispute between the two economic superpowers that is now polarising the world. During the Cold War between the US and the Soviet Union, India tended to side with the Soviets. 

But now Russia is on the same side as China, and tensions between China and India have increased recently, especially after the recent military exchange in the Himalayas. India is also part of the Quadrilateral security Dialogue (the Quad), together with the US, Japan and Australia, but at the same time is part of the BRICS gatherings together with China, Russia, Brazil, and South Africa, and it has recently struck favourable oil deals with Russia. So, India has resurrected his traditional non-aligned position, which it can afford given the size of its economy, and especially given the size of its population. During Cold War 1, India was one of the promoters of the so-called non-aligned movement, which was born after the Bandung Conference in 1955 and the Belgrade Conference of 1961.

Could Brazil do the same? Brazil certainly does not have the size of India’s economy (USD 1.6tn vs USD 3.1tn), nor India’s population (0.2bn vs 1.4bn). It is not part of a security dialogue like the Quad, and its ties with the US have been variable over time. At the same time it is part of BRICS meetings as India is, and it certainly wants to keep a good relationship with China and Russia. So, the  far left-wing Lula will likely follow the path of far right-wing Bolsonaro in keeping Brazil out of the polarisation process that is dividing the world between the friends of China on the one hand and US allies on the other. 

However, Brazil may not have the luxury to remain non-aligned for as long as India can afford. It may be forced to choose sooner rather than later. China will not want to lose its outpost in Latin America, but the US will not easily let go of the next largest country within its “backyard” of the Western hemisphere. As we discussed previously, like many other Latin American and African countries, Brazil may end up being a battlefield for a proxy conflict in this ongoing Cold War II between the US and China.  

by Brunello Rosa

21 November 2022

Last week, the news emerged that the Republicans have finally conquered a slim majority in the House of Representatives at the mid-term elections. This came after the Democrats celebrated the fact that they retained control of the Senate, with at least 50 senators. If the Democrats win the run-off election in Georgia in early December, they may even increase their majority compared to the results they achieved in 2020. The youth and pro-abortion vote proved essential for the Democrats to win in many constituencies, in a polarised society in which yet another shooting (in this case against the LGBTQ community) took place last week.

The Republicans were hoping to get control of both branches of Congress to launch an impeachment process against Biden, his management of the Ukraine war and the relationships of his son Hunter in that country before the conflict exploded. Now they can try and pass the articles of impeachment in the House - that will already be hard enough, as some moderate Republicans will likely oppose it - but it will be almost impossible to win the battle for impeachment in the Democratic-controlled Senate. 

The big question now is whether Joe Biden will run again for President in 2024. The “victory” in the mid-term election, as a red wave failed to materialise, would suggest he will, but he will make an official announcement only in January. Meanwhile, his competitor in the 2020 election Donald Trump has already announced that he will run again in 2024. Trump’s abrasive rhetoric, and the choice of “negationist” candidates who denied Biden’s victory in 2022 and then failed to win their seats in the mid-terms, was condemned by the Republicans as the reason for their defeat. So, he will again face an uphill battle to win the Republican nomination. 

Trump’s candidacy will likely freeze most of the trials against him, for tax evasion, for his responsibility in the January 6th 2021 assault to Capitol Hill, and for having illegally collected secret documents from the White House when he moved out. An independent special prosecutor will need to be appointed to continue the investigations. The Democrat-led Department of Justice was very prudent in continuing the investigation, as it would be the first time in history that a former President is criminally investigated. 

Now the paradox is that the Democrats seem willing to have Trump as their contender in 2024, as they consider him easier to beat. Whereas the Republicans would like to accelerate the trials, so that an indictment would prevent him from running for office and dividing the Republican camp once again. Meanwhile, Elon Musk, the new owner of Twitter, decided to re-open Trump’s profile, which had been banned in the aftermath of the assault on Capitol Hill, after a quick referendum with the users. 

As usual, US domestic politics has international ramifications. In particular, the Russian army decided to withdraw from Kherson and all territories west of the Dnieper river as soon as they realised that Biden will not become a lame duck. If Trump had become the most likely successor to Biden, the Russian calculus regarding the war in Ukraine would have probably changed. 

In the next couple of years, US domestic politics will return centre stage with the primary election for the presidential election of November 2024. We will continue to follow that closely, given their international implications.

by Brunello Rosa

14 November 2022

The news of the last few days seems to suggest that a bubble is bursting in the tech sector. After completing a USD 44bn acquisition of Twitter, the new owner and boss Elon Musk fired half of the company's workforce in an attempt to increase efficiency and restore profitability. A few days later, Mark Zuckerberg, the head of Meta, fired 11,000 Facebook employeeswith a simple email. During the same few days FTX, one of the major crypto exchanges, collapsed, after its arch-rival Binance pulled out of a possible attempt to rescue its competitor. All this happens as Nasdaq (the equity index specialised in tech) has been severely underperforming its more general counterpartssince the beginning of the year: Nasdaq is down 28% y-t-d, while the S&P is down 16% and the Dow Jones 7%. 

Given this background, it has been quite obvious to ask whether a bubble has burst in the tech sector. Our view is that the reports of the tech sector’s death are being greatly exaggerated, for a series of reasons. 

First of all, the recent fall in tech valuations has followed a period of massive out-performance, coinciding with the pandemic, when widespread lockdowns implied a massive use of technologies to satisfy even the most basic needs, such as the purchase of groceries. So a post-pandemic adjustment seemed inevitable. Clearly this adjustment is adding to the re-evaluation of general indices, leading to the above-mentioned underperformance. 

Secondly, this is not the first time the sector has undergone a major re-alignment of market valuations with economic fundamentals. 

The dot-com bubble burst in 2000 wiped out a large chunk of the value of the tech companies at that time, but also represented the opportunity to identify those companies that really deserved to survive. Some of them, such as Amazon, and the like, are the champions of today’s tech scene and are among the largest companies in the world by market capitalisation. As we are moving toward the so-called Web 3, it is only healthy that the champions of Web 2undergo a reality check.

Thirdly, a new wave of technological innovation is about to come online, from fin-tech, to med-tech, bio-tech, and so on. For example in the financial domain, central banks are about the enter cyber-space with central bank digital currencies(CBDCs), and cyberwarfare is now a standard companion of traditional war methodologies. This will require plenty of investment in “digital infrastructure” (servers, cables, mainframes, etc.), which will likely boost tech valuations as soon as this bear market ends. 

So, if the current episode does not represent the bursting of a tech bubble, how can we explain it? We believe that the current episode can be explained by two theories. First of all, as Hyman Minsky’s financial instability hypothesis suggests, when central banks increase interest rates, the most fragile, speculative positions tend to fail, thus determining the equity market re-pricing that we are observing in this period. Additionally, the sector is undergoing the process of creative destruction described by Joseph Schumpeteras one of the key drivers of capitalism. After this clean-up, the tech sector will be ready to re-start even stronger than before. 

by Brunello Rosa

7 November 2022

Last week, the October-November round of major central bank meetings came to an end. As discussed in our previews and reviews, the Federal Reserve increased its policy target range by 75bps, as had widely been expected. Market participants were exposed to mixed signals from the Fed. On the one hand, the Fed reassured them that, in December, a discussion would start within the FOMC regarding whether and when to reduce the pace of tightening, taking into account the cumulative actions that have been taken since March 2022. On the other hand, the FOMC statement suggested that the terminal rate would be higher than previously had been expected by market participants. The market reacted with a see-saw price action, with a net effect of there being losses in equity and bond prices. 

The Bank of England also had to provide mixed signals to the market, while increasing the Bank Rate by 75bps as well. It re-started QT and promised more rate hikes, but also said that the terminal rate would be lower than currently expected by the market. Again, market prices were volatile following the release of news by the central bank. 

These are only two examples of how policy news has been buffeting financial markets in the last few months. More specifically, the UK staged an example of how monetary and fiscal policy may end up on a collision course, with the result of causing a financial market rout, around the time of the Truss-Kwarteng mini-budget and the LDI debacle. 

But there is a more subtle inconsistency within monetary policy itself that is causing trouble for central bankers all around the world, namely the potential conflict between price stability and financial stability. 

Virtually all central banks around the world, perhaps with the exception of the Bank of Japan, are fighting inflation to restore price stability, with a combination of higher policy rates, balance sheet policies (such as Quantitative Tightening) and to a certain extent forward guidance (provided by the forecasts of terminal policy rates, for example). 

At the same time, rising rates and tightening financial conditions risk causing financial instability episodes, which would force central banks to stop their policy normalisation cycles, or even to stop their tightening cycles. In a sort of unofficial way, most central banks are now heading towards a division of labour between interest rates (devoted to price stability) and balance sheet policies (aimed at financial stability). The ECB offers the perfect example of this: while increasing interest rates, the ECB continues to provide a backstop to the eurozone bond market by re-investing the proceeds of maturing bonds in full. And even when the ECB does start its QT program, the TPI facility will ensure that bonds can be selectively purchased in order to avoid financial instability episodes emerging. 

The Federal Reserve has recently formalised this trade-off between price stability and financial stability with the introduction of a new theoretical framework. In this framework, a new rate (called r**, the rate above which a financial instability episode may be triggered) is defined besides the traditional r* (the rate at which monetary policy is neither stimulating nor restricting economic growth). If r** is lower than r*, the central banks will need to stop its pursuit of price stability sooner than its desired neutral level, in order to avoid financial instability. But even if r** is above r*, the central bank may need to stop its tightening cycle, if its desired terminal rate is above the neutral rate. 

These examples show how policy inconsistencies are here to stay, and that they will continue to determine market dynamics in coming months.

by Brunello Rosa

31 October 2022

Last week, Ukrainian forces struck the Russian fleet in the Bleak Sea with a massive drone attack in Sevastopol. The Russians are accusing the British army and intelligence services of having contributed to the planning of the attack. They have retaliated by suspending the agreement on grains, which allowed Ukrainian crops to be distributed globally. So, tensions are clearly on the rise in the Russian-Ukraine war, and the risk of a further escalation exists. 

Recently Russian President Putin said that the use of nuclear weapons is not necessary in the war in Ukraine, and that Russia is now ready to negotiate. To which US President Biden responded that his Russian counterpart is only posturing. In effect, Russian foreign minister Sergej Lavrov recently repeated what he had already said already in April 2022, namely that the current situation is as severe as the Cuban missile crisis of 1962, when the US and the Soviet Union got closest to a possible nuclear exchange during the entire Cold War. 

The real question therefore is how close we are to a potential nuclear conflict in Ukraine, and which countries such a conflict would involve. The answer to this question is quite disturbing, in the sense that of course nobody can predict with any degree of certainty how close we really are to an actual nuclear attack. By definition of using nuclear bombs as a deterrent, one country needs to use the threat to the fullest possible extent to extract as many concessions as possible from its rival, even if the nuclear weapon is never actually deployed. 

At the same time, the impression is that we may not be very far from an exchange that will include nuclear weapons. In particular, the more the Ukrainian army regains control of the provinces that were illegally annexed by Russia in recent weeks (especially in Kherson), the more likely it becomes that Putin will see no alternative other than using a nuclear device to defend the “territorial integrity of Russia.” This was the main motivation for Russia’s speeding up the annexation process of the four provinces.

The Russians are accusing the Ukrainians of wanting to prepare the use of a “dirty” bomb, i.e. a conventional bomb with some nuclear component (e.g. uranium from nuclear power plants). If that were to happen, this would certainly constitute a pretext for the Russians to use their “tactical” nuclear devices. As discussed in our previous column, these tactical devices would serve a double purpose. First, they would be intended to annihilate the morale of the Ukrainian army. Second, they would potentially inflict an irreparable wound to the continuity of the Ukrainian government.

How would the West then react? The US and NATO are not officially involved in the conflict, and certainly they are not directly involved, even though it is clear to all that the most recent advancements by the Ukrainian forces have been possible only because of the military technology provided by NATO, and especially by the US and the UK. Hence, the US cannot directly react with another nuclear strike: doing so would be the beginning of an escalation that would quickly bring to the beginning of World War III, and the end of the world as we currently know it.

So, the Americans may stage a brutal reaction which may involve weapons that may not be fully known to the Russians, or to other NATO allies, weapons that could be deployed as a one-off response to end the conflict with Russia, bringing it to a sort of perennial standstill. The questions within  US policy circles are: should they keep these cards close to the chest, so to maximise the surprise effect if and when Putin has launched its nuclear attack? Or should they publicise to the fullest extent what reaction they are ready to stage in case of a Russian nuclear attack, so as to dissuade Putin from launching it in the first place? 

A shared line has not yet emerged, but rather a sort of mixed approach, with former CIA director and US general David Petraeus saying that the US would wipe out all Russian forces in Ukraine in case of a Russian nuclear attack, but without specifying how and over what time horizon doing so would be accomplished.  Our hope is that Putin may in fact be dissuaded from launching a tactical nuclear attack by knowing that the US reaction would be ferocious. But our hope does not necessarily coincide entirely with our expectation.  

by Brunello Rosa

24 October 2022

Last week, the drama surrounding the British government came to a sudden conclusion. After sacking her finance minister Kwasi Kwarteng in an extreme attempt to save her job, Prime Minister Liz Truss had to give in and hand her resignation in as head of the Conservative party, less than two months after winning its leadership contest. As with Boris Johnson before her, she will remain as Prime Minister until a successor is found, ideally by the end of this week. 

The hope by the conservative leaders is that, if there are multiple candidates vying to replace Truss, one of the last two remaining candidates will withdraw from the race in order to avoid the choice being left to the base membership of the party, which would imply a longer process. At one point it seemed that Boris Johnson would enter the race in an attempt at staging an unexpected comeback, just a few months after leaving his position as Tory leader, but then he withdrew from the competition. At this stage, Rishi Sunak is the frontrunner of the competition.

What led to this sudden conclusion? First, Liz Truss replaced Kwasi Kwarteng with Jeremy Hunt, who is perceived to be a much safer pair of hands than Kwarteng was. From that position, Hunt performed a U-turn on the fiscal policies introduced by Truss and Kwarteng in the so-called mini-budget presented earlier in October, which we labelled as an “economic gamble.” Instead of promising GBP 45bn of unfunded tax cuts, Hunt presented a plan of GBP 41bn of spending cuts. With these moves, Hunt appeared to be the de-facto Prime Minister, overshadowing Truss and her flagship economic program. 

Second, Truss’s attempts at manoeuvring within the UK political scene proved to be totally ineffective vis-à-vis the market reaction to her economic plans. The market continued to be sceptical of her plans, and of what may have been presented in the actual budget. As a result, the GBP continued to be under the cosh, reaching almost parity with the USD. Long-term rates also continued to face upward pressure, especially after the Bank of England stopped its emergency bond-purchases program. 

The third factor behind the conclusion of these political events was the conflict between price stability and financial stability that caught fiscal policy in the middle (even if fiscal policy ended up being the trigger for the financial stability episode). In the UK, like in any other major country, central banks are focused on fighting rampant post-pandemic inflation by increasing rates frequently and in large step. By doing so, they risk triggering financial stability episodes in a fragile system, as the Financial Instability Hypothesis by Hyman Minsky would suggest. 

In this case, the episode was triggered by reckless fiscal plans that led to an increase in interest rates in the leveraged system of pension funds performing LDIs. When these funds received margin calls to cover their derivatives position, they had to sell the most liquid assets, i.e. gilts, to get the cash they needed, thus triggering a further increase in rates, until the BoE stepped in to save the day. 

The clear lesson of this entire saga is that market discipline still works, and that even those countries that pride themselves of being financially advanced, such as the UK, are subject to it. This is good news, because the market will induce governments to adopt sounder fiscal policies, at a time when they may be the only source of support to dwindling economic activity, which is at risk of soon entering a recession.

by Brunello Rosa

17 October 2022

The annual IMF meetings took place last week, and they were held in an in-person format for the first time in three years. At the centre of attention in these meetings there were of course the geopolitical developments that – as we discussed in our latest column – are having such a large impact on key macroeconomic variables, such as GDP and inflation, as well as on financial markets. 

As usual, the IMF released its updated World Economic Outlook, titled “Countering The Cost-Of-Living Crisis”. It foresaw a revision of the key macroeconomic variables consistent with a stagflationary shock: an upward revision in the inflation profile and a downward revision in the growth outlook. Global growth is now forecast to be 3.2% in 2022 and 2.7% in 2023, compared to the 3.2% and 2.9% expected in July 2022.

Another element that was clearly present at the IMF meeting was the sense of policy uncertainty that is prevailing among policymakers. In March this year, in our article titled “Is There An Optimal Policy Mix To Get The Global Economy Out Of The Current Difficult Conjuncture?” we discussed how it is very hard to reach all policy goals that policymakers are setting for themselves (i.e., higher growth, lower inflation, low long-term interest rates and to severely punish Russia for its illegal invasion of Ukraine) with the instruments at their disposal, namely monetary and fiscal policy and sanctions. In particular, we noted how monetary policy and fiscal policy risked entering into a conflict with one another: fiscal easing would be inflationary whereas monetary tightening would depress economic activity. 

Our conclusion was that policymakers would only have two solutions: either a) give up at least one of their goals, to focus instead on the others; or b) give up a bit of all goals, and achieve a sub-optimal result on all fronts. In all cases, in these circumstances policymakers cannot aim at finding an optimal policy mix, bur rather can only minimize the effects of the inevitable policy errors that they will make. 

In the last few weeks, the UK provided a live case of the point we made: reckless fiscal policy (what we called a “gamble” in our column), uncoordinated with monetary policy or even with the forecasts of the Office for Budget Responsibility, led to a collapse in the value of GBP, and a spike in long-term rates that risked bankrupting the private pension system (undertaking LDIs – Liability Driven Investment). The Bank of England had to step in to bail-out the pension system by committing to re-open asset purchases for the sake of financial stability rather than price stability. Events unfolded further, with Liz Truss forced to sack the Chancellor Kwasi Kwarteng and replace himwith the much safer Jeremy Hunt. 

The UK case made clear what had already started to become visible on the horizon: central banks can increase short-term interest rates to fight inflation and also buy long-term government bonds to ensure the financial stability of the smooth transition of monetary policy (e.g. the ECB’s TPI). This seemed unconceivable until a few months ago, as it would have represented a policy inconsistency within monetary policy, given the mixed signals that this would send to market participants. 

But in this word of policy uncertainty and absence of an optimal policy mix, we need to get used to policy inconsistencies, policy mistakes and even conflicts between the various areas of policymaking.

by Brunello Rosa

10 October 2022

This past week has been another very eventful one, from a geopolitical perspective. First, besides the ongoing cyberwarfare between the two sides, which we discussed in our recent analysis, the threat of a possible nuclear escalation in the Russia-Ukraine conflict has become even more vivid. Initially, Russian President Vladimir Putin promoted referenda in four Ukrainian provinces which he claims are under control of the Russian army: Donetsk, Luhansk, Kherson and Zaporizhzhia. Then he ratified the results in favour of the annexation of these provinces, which the international community is not recognizing. 

This was the crucial step to saying that any attack on those regions would imply a direct attack on Russia. According to the Russian doctrine for the use of nuclear weapon, any threat to the security of the Russian territory - not necessarily an actual attack, but rather any threat considered “imminent” - would justify the use of the nuclear arsenal. 

There is a lot of talk about the use of “tactical” nuclear weapons, which have a smaller radius of action. Commentators and the wider public opinion are even starting to consider the use of those weapons similar to that of conventional artillery. But they are not. Their use would still represent the beginning of a nuclear holocaust, not too dissimilar to what happened in the Japanese cities of Hiroshima and Nagasaki at the end of WWII. Hiroshima and Nagasaki have been in fact quoted many times by the Russian government in their rhetoric, to justify the use of Russia’s nuclear arsenal. This is the reason why US President Biden spoke about a potential Armageddon that would derive from such a possible move from the Russians. 

We need to hope that the nuclear escalation does not progress further, as it is unclear how it would end. The bombing of the Kerch bridge that connects the Russian mainland to Crimea meanwhile might represent another starting point for further escalation, which is the reason now nobody wants to claim to be the author of that attack. 

Also taking place this past week, the OPEC+ cartel decided to cut oil production by around 2m barrels a day, in order to support falling oil prices and keep the price close to 100$pb. The move clearly benefits Russia at this difficult juncture in its war with Ukraine, and it could have never been adopted without the decisive input of Saudi Arabia, the major stakeholder of OPEC. 

This confirms what we discussed in our column of a few weeks ago: the emergence of a new bloc of countries, established around the BRICS gathering and now including Saudi Arabia as well  and that is in direct competition with the G7, which is centred around the US. In one of our recent papers, we discussed how Saudi Arabia was re-gaining centre stage in the more multipolar world that is currently emerging.

This is the reason why both President Biden and US Treasury Secretary Yellen complained about the cut to oil production inspired by Saudi Arabia, which risks tipping the global economy into a recession. And all this while the EU struggles to find a unified position around the proposal of a price cap for oil and gas imports from Russia.

These are just some of the examples that show that geopolitics remains at the centre stage in world affairs, and is one of the main determinants of key macro-financial variables, including oil prices (a crucial input for headline inflation) and GDP.

by Brunello Rosa

3 October 2022

Last week the UK went through one of the most dramatic periods of its recent history. The events started with the not so-mini-budget that was presented on Friday, September 23rdby the Chancellor of the Exchequer Kwasi Kwarteng, which we discussed at length in our previous column and subsequent podcast.  

As we argued in our column, the fiscal measures introduced by the Chancellor represent an economic gamble, as they consist of unfunded tax cuts worth GBP 45bn, to be added to the roughly GBP 100bn of measures that were adopted to cushion the effects of the energy crisis on households and companies. This would imply an additional GBP 150bn of borrowing by the government; i.e. gilts to be issued by the Treasury and presumably absorbed by the market. All this, without any forecast on economic growth and related fiscal deficit projections by the Office for Budget Responsibility (OBR), which generally accompany the issuance of the budget.

The results of these decisions have been disastrous. Investors have started to ask for higher yields to absorb the upcoming extra borrowing planned by the UK Treasury. Pension funds have been caught in margin calls, which forced them to sell even more gilts to get hold of cash to close these margins. This has made the price of gilts collapse and their yields rise rapidly. To stop this vicious circle, the Bank of England had to step in and launch an emergency program of GBP 65bn of purchases of gilts to be carried out over the following fortnight. Meanwhile, the GBP collapsed to its lowest level in recent history. Tory MPs threatened a no-confidence vote on Truss just weeks after having chosen her as their new party leader. Truss and Kwarteng had to meet with the OBR in order to inject confidence into the market, even though the meeting did not end with any sign of a policy U-turn by the government. 

The question we are asking ourselves is the following: is there any lesson that Giorgia Meloni, likely to be appointed PM in Italy, may learn from Liz Truss? After all, Liz Truss, in spite of all her shortcomings in communicating her policy intentions to the public, is an experienced politician and member of government, who studied Philosophy, Politics and Economics, the famous PPE course of the University of Oxford attended by many prime ministers before her. And Kwasi Kwarteng, after studying at Eton, has obtained various degrees, including a PhD at Cambridge University. In spite of these prestigious pedigrees, they made a mess of their first few days at the helm of the government.

Giorgia Meloni and her closest aids lack the academic background of her UK counterparts, so she may seemingly be starting at a disadvantage. Yet she may be able to learn a few lessons from what happened to Truss and so avoid making the same mistakes. The first lesson to learn is that being a person of conviction only buys you some time and credibility: it is the test with reality that makes the difference, especially if one is extremely convinced about the wrong ideas. The second lesson is to always be surrounded by the best people you can find, not just by acolytes and minions. Finally, never challenge the markets if you have a large amount of debt to refinance. You may end up needing to  ask for the intervention of the central bank. In the case of Italy, this is now mediated by the eligibility for TPI, which is subject to a high degree of discretion by the ECB.  

As we said in our preview, we do not expect Giorgia Meloni to start her period of PM with bellicose intentions. However, as Liz Truss shows, a couple of wrong moves may transform the honeymoon phase into a debacle. Giorgia Meloni may end up being on a collision course with the markets and European authorities before show knows it.

by Brunello Rosa

26 September 2022

Last week was an eventful one. On Wednesday, the US Federal Reserve increased its policy target range by additional 75bps, to 3-3.25%. On Thursday, the Bank of England increased its policy rate by 50bps to 2.25% in order to tackle rampant inflation. And on Sunday general elections were held in Italy. Russian President Vladimir Putin meanwhile announced the partial mobilisation of Russians of fighting age, which most commentators interpreted as an escalation of the war. 

While these events were taking place, on Friday the new UK Chancellor of the Exchequer, Kwasi Kwarteng announced its Growth Plan for the UK, which, according to its proponents, represents the “biggest package of tax cuts in generations.” The fiscal package, which is larger than a regular budget, will be comprised the following measures:

For households, a) the basic rate of income tax will be cut to 19% in April 2023, one year earlier than planned; b) the 45% additional rate of income tax will be abolished; and c) there will be changes made to the Stamp Duty regime for homebuyers, with 200,000 people expected not to pay the tax altogether each year. This comes a day after the government announced that the Health and Social Care Levy (HSCL) of 1.25%, due to be introduced from April‌‌‌ ‌‌2023, will not be implemented, and that the 1.25% increase in National Insurance contributions (NICs) rates that was introduced in April 2022 will end on 6‌‌‌ ‌‌November 2022.

For companies there are planned tax cuts as well, in particular: a) the cancellation of the planned increase to the Corporation Tax (CT) main rate from 19% to 25%, with changes made to the dividend tax rate; b) the cancellation of the planned increase in the rate of Diverted Profits Tax from 25% to 31%, and the planned reduction in the Corporate Tax surcharge rate for banking companies, both of which are expected to take effect from 1‌‌‌ ‌‌April 2023; and c) the introduction of new investment zones around the UK where enhanced tax reliefs will be offered for Stamp Duty Land Tax (SDLT), Enhanced Capital Allowances, Structures and Buildings Allowance and Employer National Insurance contributions.

The government expects these tax cuts to increase the UK’s growth potential from 1.75% to 2.5%, and to increase productivity and wages over time. Considering as well the measures that were introduced in previous weeks, in particular the Energy Price Guarantee that was made in response to the large increases in gas prices that are being experienced by households and companies, how credible are these promises? 

The Bank of England, in its latest statement, said that it will assess the overall impact of these measures on growth and inflation, and their implications for monetary policy, in the November 2022 Monetary Policy Report. In its preliminary assessment the BoE announced that by increasing disposable income the energy price cap may induce stronger spending, which could be inflationary. 

Therein lies the real risk, which we discussed in previous analysis. Monetary policy and fiscal policy are not working in the same direction anymore. To the contrary: fiscal easing to support economic activity tends to be inflationary, whereas monetary tightening to combat inflation tends to be recessionary. The monetary-fiscal coordination that worked so well during the pandemic is now a distant memory. And the biggest problem is that an optimal policy mix does not even exist. 

The UK government does not seem to have understood this point. It has introduced a massive plan of tax cuts as it was operating in isolation, without considering the potential inflationary impact, at the same time as the BoE is trying to tame inflation with higher rates and QT. Moreover, these tax cuts imply much larger borrowing, which may also result in higher long-term rates, which in turn tend to depress economic activity. 

Markets have been fast to provide their response, with the GBP sinking versus the USD to one of its lowest points on record. Voters in the UK seem to have expressed their view as well, with polls showing a solid Labour lead (42% versus 33%, with LibDems, SNP and Greens – all potential allies of Labour – polling at 20% collectively). Liz Truss should learn from Margaret Thatcher, whom she considers to be her role model. Thatcher did increase taxes, including the hated VAT, before cutting taxes. And her government collapsed on the proposed introduction of the poll tax, intended to finance local governments. 

by Brunello Rosa

19 September 2022

Italy will hold a general election this Sunday, to elect its 19th parliament since the return of democracy in 1948. This will be an early election, called after the resignation of Mario Draghi in July following the de-facto loss of confidence by parliament in Draghi’s government. The no-confidence process was started by M5S’s leader Giuseppe Conte, but ultimately it was Berlusconi’s Forza Italia and Salvini’s Lega that pulled the plug, leaving only Enrico Letta’s PD to support the government.  

This election will be peculiar mainly for two reasons. Institutionally, following the 2020 constitutional referendum, the number of MPs has been drastically reduced, from 630 to 400 Deputies for the Chamber, and from 315 to 200 Senators for the Senate. This also has a political implication, since the constituencies have also been re-designed, with more weight now being given to peripheral areas and suburbs, and less to city centres where the centre-left is traditionally stronger. 

Politically, the general election is widely expected to result in a landslide victory by the centre-right, led by Giorgia Meloni of the Fratelli D’Italia (FdI). This is due to the fact that FdI was the only party officially in opposition to Draghi’s government in parliament. After the fall of Draghi’s government, she therefore emerged as the only credible alternative to the status quo. Also, the decision by centre-left parties (the PD, the M5S and the so-called Terzo Polo of Azione + Italia Viva, both of which splintered from the PD during this parliament) not to run in a coalition will likely allow the centre-right to win all the first-past-the-post seats, which are around 1/3 of the total number of seats (the rest are elected with a proportional representation system), likely leading to a massive defeat. 

On the other side of the political spectrum, FdI is likely to be by far the most voted for party in the centre-right coalition, which should imply that Meloni becomes the most obvious candidate to become Italy’s next prime minister. Things may change depending on the overall electoral results, and, in particular, on the results within the centre-right, and the distance between the first and second party in their coalition.

The latest available poll shows that FdI is at 25.3% of voting intentions, PD at 23.3%, Lega at 12.3%, M5S (12%), Forza Italia 6.7%, Azione + Italia Viva 6.4%, and the Greens and Left together 4.1%. If the eventual outcome of the election is similar to these polls, with FdI having a number of MPs almost double than that of its immediate follower, Lega, then Meloni can legitimately claim to become Italy’s next PM. 

What would a Meloni government do? In our opinion, there are two scenarios to consider here. If the centre-right wins enough votes to be able to change the Constitution without requiring a confirmative referendum – it will need a two-thirds majority in each chamber of parliament in order to do so – then we believe the centre-right coalition will devote most of its energy to changing the Constitution towards a presidential or semi-presidential system in which the head of state is elected directly by the people. 

If instead the centre-right wins “only” a simple majority, it will devote most of its energy on the economic front. It will likely review the recovery plan (PNRR) and pursue a tax reform to introduce elements of a flat tax. 

In any case, markets seem relatively relaxed at this stage, in spite of Italy’s large debt/GDP ratio. Partly this is because growth has lately surprised on the upside, and the fiscal deficit on the downside. But things may change rapidly if Meloni, unwisely, decides to set Italy on a collision course with the EU on economic or rule-of-law themes.

by Brunello Rosa

12 September 2022

Last week, Elizabeth II, Queen of the United Kingdom and other Commonwealth realms, died at the age of 96. Her kingdom lasted 70 years, making her the longest-serving monarch in British history. Only months ago the country celebrated the platinum jubilee of her accession to the throne, which took place on 6 February 1952, when she was just 25 years old. During her life, Queen Elizabeth has appointed 15 prime ministers, the first one being Winston Churchill, the last being Liz Truss.

The world has changed around her during her time as Queen. The first US President she met was Harry Truman, who succeeded Franklin D. Roosevelt; the last one was Joe Biden. In between these, she met with diverse characters such as John F. Kennedy, Richard Nixon, and Barack Obama. The UK has gone through tragedies and humiliations such as the Suez Crisis in 1956, and triumphs such as the Falklands war in 1982. During her kingdom, the UK entered the EU (in 1973) and later exited it (2020), and London has become the world’s foremost financial centre.

Overall, during this long span of time, the UK has certainly increased its influence and prestige at the global level. 

Domestically, the UK has gone through difficult periods, such as the troubles in Northern Ireland, which ended only in 1997 with the Good Friday agreement. In 2014, the UK survived an independence referendum by Scotland. So, one can say that, during the second Elizabethan era, the UK has strengthened domestically and on the global stage. Elizabeth leaves a heavy legacy for her successors in this regard. 

King Charles III will have to begin from where his mother left. His name is a difficult one. Charles I was the first king executed in European modern history (in 1649, more than a century before the French Revolution). Charles II was forced to live in exile during the rule of Oliver Cromwell as Lord Protector of the UK, and was able to return only at the death of the dictator. Charles III will be confronted with phenomenal secession pressures, from Northern Ireland and from Scotland. 

As we discussed in our previous column, the victory of the Sinn Fein on the two sides of the isle of Ireland makes a re-unification referendum for the island more likely. On that occasion we said that such a referendum would not take place while the Queen was alive. But now the clock is ticking, and it will take some serious effort by Charles to convince Northern Ireland that they are better off inside the UK rather than within the EU. This task will become even harder, as Liz Truss has declared her intention to re-discuss the Northern Ireland protocol with the EU. Meanwhile, regarding Scotland, First Minister Nicola Sturgeon has also said that it intends to launch a new independence referendum by 2023. Anow that the UK is out of the EU, pro-European Scotland may opt for the independence route. 

Domestically, Charles will likely oversee an autumn and winter of severe discontent among the UK population, given the cost-of-living crisis originating from the rise in energy prices. 

For all these reasons, a very steady hand will be needed to keep the country together and drive it out of this current difficult situation. This is the reason why Charles has immediately appointed his son William as Prince of Wales, making him a de-facto right hand to the throne, in the hope that this “duumvirate” will help Britain navigate the new few difficult years. 

by Brunello Rosa

5 September 2022

At the and the end of last week, the figures for US Non-Farm Payrolls (NFP) were released. The US Bureau of Labour Statistics reported that the US economy added 315K jobs in August of 2022, compared to a downwardly revised 526K in July (p. 528), but above market expectation of 300K and pointing to broad-based hiring across many sectors. Even if the unemployment rate rose slightly from 3.5% to 3.7%, non-farm employment is now 240K higher than its pre-pandemic level in February 2020. 

On the basis of these figures, even if employment figures are a lagging indicator of economic activity, it may be correct to say that the US economy is not in a recession, not even a technical one, in spite of two consecutive quarters of contraction. This seems to be confirmed by a cross-check through the lense of the so-called Okun’s law, which links unemployment and GDP changes. According to a recent analysis, the US economy may have actually been growing in H1. This is crucial in determining what the Fed, and other major central banks, will do in coming months. 

Regarding the Fed, at its traditional gathering in Jackson Hole Chair Powell surprised the market with unexpectedly hawkish remarks. Powell said that the US economy remains strong and the world economy resilient in the face of the ongoing energy crisis deriving from the war in Ukraine, and therefore the FOMC will continue tightening its policy stance.  The FOMC will continue aiming for a “soft landing” of the economy, but the Committee priority is now to bring inflation (which is still running at 8.5% y/y) back to target. Commentators and markets read this as an anticipation that another 75bps rate increase will be delivered in September. In July, Powell clarified that the Fed will not provide as much forward guidance as before, as the FOMC has become data dependent, but this seems now a reasonable assumption. 

But more than the decisions that the Fed makes in any given meeting, what matters is the cumulative amount of tightening that takes place. In this respect, the Fed has recently reached neutral territory with its policy rate (2.50%), and it is ready to enter restrictive territory with the next rate increase, to reach and overcome the 3-3.25% expected at year-end according to its SEP dots. However, one should note that with inflation at 8.5% and a policy rate at even 3.5%, policy rates would still be negative in real terms, meaning that in real terms the Fed’s policy stance remains highly accommodative. To bring inflation down to 2%, much more tightening may be needed. 

Regarding the ECB, next week another 50bps rate increase is expected, but perhaps a surprise 75bps hike cannot be ruled out. This follows the remarks by ECB Board Member Isabel Schnabel, who said that the ECB may need to make further “sacrifices” (i.e. rate increases) as the inflation outlook has not improved. Additionally, the ECB’s policy stance cannot remain too distant from that of the Fed, at a time when the EUR has already fallen below parity versus the USD. A weaker currency contributes to higher inflation rates, at a time when the ECB is trying to bring inflation back to target. 

by Brunello Rosa

29 August 2022

A few weeks ago, after Boris Johnson resigned as UK Prime Minister, we published a column titled “Johnson’s Resignation Opens The Gate To A Real Post-Brexit Britain.” In that column we discussed the possible contenders for the leadership race, indicating Rishi Sunak and Liz Truss as the clear frontrunners. We also warned that, once that Brexit was “done” by Boris Johnson, the new Tory party leader and future PM will have to deliver on what Brexit will really mean for the country; in particular, by showing what benefits it could derive from leaving the EU. 

This week, the leadership race will come to an end, with the election of Johnson’s successor by 161,000 Tory party members on September 5th. Liz Truss is widely expected to win the race. Sunak has been one of the most popular ministers in Johnson’s cabinet, widely praised for his sensible approach to the pandemic, which was epitomised in the furlough scheme that was launched to make sure that millions of people did not lose their jobs. But Truss has been a party member far longer than Sunak, and she is clearly favoured by the party grandees, as well as by the base. She comes from the party ranks, and can probably speak to the belly of the country better than Sunak can. 

In spite of the humble origins of his family, Sunak would seem an elitist choice, considering his business studies at Stanford and his marriage with the daughter of one of the richest men in India. The fact that his wife was caught using a legal scheme to pay less taxes in the UK did not help. Sunak would speak to Britain’s minds. But in a period in which populism is still in vogue, speaking to the belly of the country goes a longer way than speaking to the mind. This is the reason Liz Truss will likely win the race. 

We have already discussed the differences in policies between Sunak and Truss; a further comparison between the two can be found here. But there is an aspect of the difference between them that it is worth discussing in greater depth. Let us assume that Liz Truss wins the race. She is considered to be a die-hard Brexiter, with a level of zealotry that only “the converted” have (she voted to remain in the EU in 2016). 

Truss reportedly wants to transform the UK in a sort of Singapore-on-Thames, with a super low tax rate. Hence, her proposal of reducing taxes by GBP 30bn from “day one” in office. She also wants to reduce the regulatory burden, to take advantage of the divergence in standards with the EU that the UK has gained from Brexit. She also wants to revisit the Northern Ireland protocol, which regulates the relationship between UK and the rest of the EU at the Irish border. In terms of economic policy, she is clearly in favour of tax cuts over “cash handouts.” But even Margaret Thatcher increased taxes (for example VAT), before announcing tax cuts, years later. 

Some commentators say that “Liz Truss can do a lot of damage before she’s thrown out, as she will be, in 2024.” Others believe that, “If she wins, and enacts her promise of immediate tax cuts, the only safe prediction is that sterling will crash.” While we are somewhat concerned by her proposed policy, we believe that Truss is likely to show to the UK what Brexit really means, in both a positive and a negative sense.

by Brunello Rosa

22 August 2022

Since mid-June 2022, the S&P 500 equity index has risen more than 15%, reaching 4228 points at the end of last week. This rally has helped the index (and similar indices around the globe) exit bear market territory, defined as a fall in equity prices of at least 20% from its recent peak, which it entered in June just before this rally begun. 

The index is still down 11% year-to-date, but only 5% from one year ago. It is actually up 45% over the last three years, and an astonishing 500% since March 2009, when the post-Global Financial Crisis (GFC) rally begun. The index has been one of the major beneficiaries of the massive liquidity injections made by central banks around the world in the last 14 years, with various round of QE to combat the various shocks the global economy underwent in the period, and in particular the GFC and the Covid-19 pandemic.

This introductory background serves the purpose of providing some context for one of the hottest debates among market participants in this period; namely, will this mid-summer market rally last, at least until the autumn, and possibly beyond? As we know, market participants tend to have a short-term horizon for their decisions. But putting things into context here may help to provide an answer. 

We discussed recently about the asynchronous nature of financial and business cycles, with financial cycles typically anticipating the developments of the real economy. In this context, we warned that we could see markets rallying when the economy was entering a recession, having fallen in advance, before the economic cycle turned downward. In this case, the key indicators that markets are watching are inflation data and the response of central banks. If inflation starts showing signs of peaking and central banks signal that they can stop their tightening cycle soon, markets would be ready to rally. 

This is what has fuelled the mid-summer rally so far. Inflation has shown some (mixed) signals of peaking, and the Fed, at its July FOMC meetings, said that it is now data dependent, and not on a pre-set course of action. 

What about the future? The real economy shows further signs of deceleration globally, starting in China and Europe, and a contraction in economic activity taking place at the end of this year cannot be ruled out. The US has already exhibited two consecutive quarters of negative growth meanwhile, but various one-off factors seem to convince policymakers that this still does not represent even a technical recession. 

On the other hand, labour markets remain tight, on both sides of the Atlantic. And with unemployment rates still at historical lows, wage growth remains strong, pushing up domestically generated inflation. In the UK, for example, inflation has surprised on the upside again, and market participants now expect another 50bps rate increase in September by the Bank of England. 

Central banks will not stop increasing rates until they are sure that inflation is tamed, even if this implies a strong deceleration, and potentially even a contraction in economic activity (to some extent, this is in fact what central banks are trying to engineer). Central banks, which have a longer time horizon than market participants, know that markets can suffer some additional losses (precisely because some equity indices have rallied 500% since the QE experiment began), if such losses are the price needed to pay for reining in inflation. So, the mid-summer rally may come to an abrupt halt when central bank activity resumes in September. 

The real puzzling piece in this jigsaw is the following: if a debt crisis accompanies the upcoming economic downturn, the reaction function by central banks may change, and they may instead be more inclined to safeguard the integrity of the overall financial system rather than rapidly bringing inflation down to target levels. But in that case, more wealth destruction in the equity and sovereign and corporate bond markets would be assured, even with less hawkish – or even accommodating – central banks.

by Brunello Rosa

15 August 2022

The visit to Taiwan by US Speaker of the House Nancy Pelosi on August 2nd, and the reaction to that visit by the Chinese authorities, were widely reported upon by all media outlets. Pelosi had programmed her visit for April 2022, the first trip by a senior US lawmaker since House Speaker Newt Gingrich’s visit in 1997; but her trip was cancelled due to Covid-19. Already at that time, the Chinese Ministry of Foreign Affairs said that the visit was a “malicious provocation” and that the People’s Republic of China (PRC) would “take strong and resolute measures to thwart any interference by external forces”.

In effect, the reaction by the Chinese authorities was resolute. On 1st August, the PRC announced a military exercise opposite Taiwan. A military build-up was also seen in cities and on beaches directly opposite Taiwan. The Chinese military has also continuously sent fighter aircraft and naval ships over the median line and into the Taiwanese Air Defence Identification Zone (ADIZ). These drills have also been planned for areas east of Taiwan. During Pelosi’s stay, various Taiwanese government sites were hit by DDoS attacks, bringing down the Office of the President’s website, the Ministry of Defence website as well as the website of the Taoyuan International Airport. 

Since the Russian invasion of Ukraine, many commentators said that China was keen to establish a new, privileged relationship with Putin’s country because this invasion would legitimise, at some point, the Chinese invasion of Taiwan. But things are a bit more complicated than this. 

First, already in July 2021, six months before Russia’s invasion of Ukraine, we said that China would aim at taking back the “rebellious province” of Taiwan over the next 5 to 10 years, initially with a series of destabilising actions and provocations. The Chinese government will likely use a tactic not dissimilar from the one it adopted to take back control of Hong Kong. 

Secondly, we said that China would not make such a move this year, as many had expected, simply because Chinese President Xi Jinping’s energy is devoted to being re-elected as party leader for the third time (effectively paving the way to a lifelong tenure as Chinese leader, irrespective of the official title) during the upcoming 20th Congress of the Chinese Communist Party (CCP). A war with Taiwan, which may have unpredictable consequences, would likely cause more harm than good to Xi’s hopes of re-election, paving the way for a victory of the opposing factions within the CCP, and in particular the faction led by Prime Minister Li Keqiang. 

Third, and perhaps most importantly, when geopolitics is in flux, unexpected events may develop which make “mechanical inferences” less obvious than they would seem to be, prima facie. For example, recently Putin – the arch-enemy of the enlarging NATO alliance – and Erdogan, the President of Turkey, a long-time NATO member, decided to deepen the economic ties between their respective countries. Initially Erdogan established himself as the mediator between Russia and the West to free the grain stuck in Ukrainian ports (chiefly Odesa) besieged by the Russian army.

But during the meetings, which led to a partial unfreezing of those crops, badly needed to avoid famine in many African countries, Erdogan and Putin clearly found time to speak about their own respective interests. Although not many details were released of the intended increased cooperation, Western countries fear that Russia may find a way to circumvent the West’s sanctions, and that Turkey may be less aligned with the rest of the alliance in its opposition to Russia. 

This example shows how the war in Ukraine, which has polarised the world, has set in motion the entire geopolitical landscape, and that – in any case – a new world order is likely to emerge in coming years.

by Brunello Rosa

08 August 2022

At the beginning of H2 2022, the world’s largest central banks have all delivered substantial monetary policy tightening. The first of these (in chronological order) was the European Central Bank, which on 21 July delivered a 50bps rate increase, bringing the deposit rate back to zero, despite expectations of a 25bps initial increase in all three rates of the so-called “corridor”. 

There were two main motivations behind the ECB’s decision. First was that inflation surprised on the upside compared to the forecasts released just a few weeks before in the June macroeconomic projections. Second was the simultaneous introduction of the Transmission Protection Mechanism (TPI), which is designed to reduce the fragmentation in the transmission of monetary policy. Without that instrument, the ECB should have been much more cautious in increasing rates, as the sovereign yields of the most fiscally-exposed countries (chiefly, Italy) were increasing much more than was warranted by expectations of a tighter monetary policy stance. 

After the ECB, the Fed, at its July 20 FOMC meeting, carried out its second 75bps rate increase in a row,  the first having beendelivered in June. This was motivated by the need to bring rates into neutral territory (the upper end of the Fed funds corridor is now 2.50%, in line with the “longer end” forecast for the policy rates in the SEP dots), as inflation continued to surprise on the upside. Additionally, the Fed has also speeded up the pace of reduction of its balance sheet, to increase the overall amount of tightening in its policy stance. 

Somewhat paradoxically, the market welcomed this second larger rate increase with a relief rally, as the Fed also changed its forward guidance. Chair Powell said that the Fed will not provide multi-meeting guidance anymore, as the FOMC will instead decide meeting by meeting, as it has become data dependent. However, the latest very strong Non-Farm-Payroll figures for August, showing a 528K addition of jobs (much more than the 250K expected and even above the 398K addition recorded in July), may induce the Fed to deliver another 75bps increase in September. 

Finally, on August 4th, the Bank of England delivered a 50bps increase in its Bank Rate, bringing it to 1.75%, its largest rate increase for 27 years. Its Monetary Policy Committee, which had been split 6-3 in favour of a 25bps increase in June, moved to an 8-1 split for this larger move. This decision was motivated by the continued upward surprises of inflation, which is now expected to reach 13%, in spite of the incipient recession. In its latest Monetary Policy Report, the BoE now expects a contraction in economic activity to occur at the end of 2022, and to last for five quarters, one of the longest recessions in recent decades. 

So, given the above background, with inflation continuing to surprise to the upside and labour markets still strong in the US, the EZ and the UK, it is likely that central banks will need to continue their job of reining in inflation with unrelented determination in coming months. The only element that could make them think twice is the beginning of the recession that some of them are predicting (while others are still, delusionally, denying that it will take place). A recession that may be caused, also, by the very tightening of monetary policy that central banks are undertaking in order to control inflation.

by Brunello Rosa

01 August 2022

Last week, the US recorded a second consecutive quarter of negative growth (-0.9 q/q SAAR), after Q1 1.6% contraction. Traditional economic theory would suggest that the US has entered a technical recession, however prominent economists and policymakers suggest this may not necessarily be the case. Former US Secretary of the Treasury Lawrence Summers said that the US is not in a technical recession because the largest negative contribution to GDP growth came from a drawdown of inventories, which is partly a sign of the economy’s strength. In effect, inventory decumulation provided a -2% contribution to Q2 growth, while export and consumer spending provided positive contributions. 

Previously, Federal Reserve Chair Jay Powell saidthat, even in the case of two consecutive quarters of negative growth, the US would not be in a technical recession because the first quarter’s negative figure may be due to residual seasonality (and may be revised subsequently), and that the broad-based contraction in economic activity that is typical of a recession is not yet there, in spite of the clear weakening of growth observed by the central bank in Q2 2022.

So, the question remains: are the world’s major economies entering a recession at some point this year? If inflationary pressures persist, if the energy crisis intensifies, and central banks continue to increase rates to combat rising prices, it is almost inevitable that between Q4 2022 and Q1 2023 a recession will begin. While a vast majority of economists expect that such a recession, if it does occur, will be shallow, Nouriel Roubini expects it to be sharp and prolonged, given the stagflationary global debt crisis that is accompanying it. Even if those conditions mentioned above do not materialise all at once, it will still be very difficult to avoid some form of hard landing, in spite of central banks’ best efforts. 

Let us assume then that some form of recession will materialise between 2022 and 2023. What would the implications of this be for central banks and markets? Central banks would likely have to stop increasing rates, as the recession will cause the tightening of economic and financial conditions that central banks are pursuing with their current policy actions. Money market futures do predict that the Fed and the BOE, for example, will cut rates in 2023. We expect a deceleration in the pace of tightening from the Fed and the ECB towards the end of 2022. 

As far as markets are concerned, investors celebrated Powell’s words accompanying the Fed’s second consecutive 75bps rate increase in July with a relief rally. Powell said that the Fed will decide its policy meeting by meeting, since it is data dependent; in the past, when central banks become “data dependent”, this has generally been seen as anticipating a shift in stance, in this case towards a less aggressive posture. So, is it possible that, even as the economy is about the enter its worst phase, financial markets will hit  bottom and start recovering? 

Well, yes, it is entirely possible that this will occur, given the asynchronous nature of the financial and business cycle. Financial markets tend to anticipate what happens to the real economy (and even more so the labour market, which is a lagging indicator), as they are able to immediately reflect new information into prices (if one believes in the “efficient market hypothesis”). Over the years, empirical models have been developed to formalise this relationship. For example, an inversion of the yield curve (as is the case in the US currently) is considered to be a predictor of an upcoming recession. Equity markets tend to hit bottom a few quarters before a recession ends (as happened in March 2009 in the US, for example). But even Hyman Minsky’s “financial instability hypothesis” suggests that the financial cycle turns well before business cycles do. 

In coming months therefore we may observe financial markets bottoming out, while the economy tanks. There is one big caveat here, though. If the recession morphs into a systemic crisis, for example by triggering a stagflationary debt crisis – as Nouriel Roubini suggests may happen – then both equity and bond markets may experience another leg down, as commodity prices continue to increase given supply bottlenecks and the impact of the war in Ukraine.

by Brunello Rosa

25 July 2022

The last few weeks have been extremely intense from a political risk perspective. First (as we discussed in a recent column), the UK government nearly collapsed after a rebellion – almost a mutiny – of a large part of its components took place, which effectively forced Boris Johnson to resign from his position as leader of the Conservative Party. Johnson said he will remain as PM until a successor is found, which will happen on September 5th. Then in Italy a sudden government crisisinitiated by M5S leader Giuseppe Conte led to the dissolution of parliament and early elections, which will take place on September 25th. PM Draghi will remain in power until then, to discharge the government’s “current affairs.” 

Incidentally, one may notice how Boris Johnson and Mario Draghi have been among the fiercest opponents to Putin in his war in Ukraine. The UK was certainly the largest provider of weapons to Kyiv. Italy has been the most decisive proponent of a European “price cap” on gas, a measure that requires the support of the US for an effective enforcement, which would damage Russia’s energy revenues far more than the embargo on oil imports, as the latter merely reduces the quantity of oil available and so increases the prices. These two fierce enemies of Vladimir Putin will be soon out of power. 

The question is: who is going to come to power after these two leaders? 

In the UK, it seems that the populist era is about to finish with the end of Johnson’s tenure in office. The race for succession in the Tory party is now down to two main candidates: Rishi Sunak and Liz Truss. The differences in policies between the two are not massive, but are still significant. Each candidate represents a different era of the Conservative party. Sunak supports a return of the “old” tradition of the Tory party of being fiscally prudent; it has led to the proposed increases in national insurance contributions to finance the expansion of the NHS after the pandemic, as well to as an increase in corporate tax rates. Liz Truss meanwhile speaks to the more neo-liberalist component of the party, which seeks lower taxes to boost growth. 

In both cases however, it seems that the period of “comforting fairy tales” – to use Sunak’s expression in his letter of resignation from Chancellor –  for example, of the positive impact of Brexit on the UK economy, is over with the end of Johnson’s populist premiership, and a return of a more pragmatic and less ideological Tory leadership is imminent. 

In Italy the opposite seems to be happening. After 17 months of the technocratic government led by Mario Draghi, which allowed Italy to start reaping the benefits of the EU’s Recovery plan, all signals point to a possible victory of the centre-right coalition. Each component within such a coalition is a reason for concern, to say the least.  

The old patriarch of the coalition, Silvio Berlusconi, is the man who brought back populism in Italy after the fall of the so-called first republic. His first promises now (to increase to EUR 1,000 per month each pension below that threshold) are already reminiscent of the famous “less taxes for all” of 1994, when he won his first election. Just to give an idea of what his return to power could mean, fulfilling that promise alone would cost at least EUR 60bn, three times what Italy will get from the EU if it respects all the milestones of the Recovery plan by December. 

Matteo Salvini’s Lega meanwhile continues to have anti-Euro positions even after participating in Draghi’s government. Those positions already led to a large widening of bond spreads in 2018, at the time of the M5S-Lega government. Finally, Giorgia Meloni’s Brothers of Italy, which enjoys the leading position in voting intentions (around 23-24%) according to recent polling, is an almost unknown quantity. As the New York Times recently said (in an article titled “The Future Is Italy, and It’s Bleak”), what most people know about Meloni and her party is that they come from the post-fascist tradition, and that its economic plans are obscure.

Clearly there is a risk of a return to populism with a vengeance after the September election in Italy.  Such a return would likely lead to a renewed widening of intra-EMU spread, which the ECB will have hard time to consider “unwarranted,” as it did already in 2018.

by Brunello Rosa

18 July 2022

A government crisis occurred in Italy last week. The Five Star Movement (M5S), a major component of the national unity parliamentary majority, did not participate in the confidence vote over the Draghi government’s large package of fiscal aid for households and businesses hit by the cost-of-living crisis. The M5S’s parliamentary group had recently splintered as the faction loyal to foreign minister Luigi Di Maio formed a new group (Insieme per il Futuro, IPF) to support Draghi in his anti-Russian and pro-American stance.

Theoretically speaking, Draghi, having received the confidence vote both from the Chamber and the Senate (in this latter case, with an absolute majority), could have continued to govern and disregard this rebellion. But Draghi wanted to highlight the political relevance of the event. He went to Italy’s President Sergio Mattarella to resign, but Mattarella rejected the resignations and invited Draghi to go back to parliament this Wednesday, to “verify” the existence of its parliamentary and political majority. What will happen next? 

Draghi is reportedly tempted to give up. Apparently he is tired of the cross-vetoes on all major pieces of legislation from the parties supporting his government. We anticipated that the various components of his composite majority could start dis-engaging with one another by autumn or winter, as the 2023 elections approached. But clearly the M5S wanted to exploit the first-mover advantage and leave the majority before anyone else, to spend a few months in opposition and regain the sort of anti-system credentials it has often had before the general election. 

The problem is that, once a component element of Draghi’s parliamentary majority leaves, there is a strong incentive for all other components to do the same, instead of being held responsible for continuing to support a semi-technocratic government, even if for the greater good of the country. Thus Draghi will either manage to obtain a strong commitment from all remaining parties (and the component of the M5S that is still loyal to him), that they will support his government until the end of this parliament, without undermining his action with continued cross-vetoes – in which case the government will carry on – or else Draghi will clarify in parliament that the conditions to continue his tenure do not exist anymore, and he will resign. 

Whatever happens, something is clear: political risk is on the rise in Italy. And with it, the 10y BTP-Bund spread, which has reached 220bps recently. And all this is happening during the week in which the ECB is expected to unveil its new anti-fragmentation facility, which is aimed exactly of containing the widening of spreads, when unwarranted by fundamentals. Italy is expected to be the largest and most relevant beneficiary of this facility. And just at the time when the technocrats in Frankfurt need to decide the crucial details of this facility, Italy is providing a clear example of a warranted increase in its sovereign yields and widening of the spreads, justified indeed by the rise of domestic political risks. 

Italy is also supposed to be the largest recipient of the recovery funds from the EU, agreed upon during the pandemic. These funds can only be unlocked if Italy approves the necessary reforms, with the last batch expected to be finalised at the end of the year. 

So, in theory money could be ready to help Italy recover from its traditional economic underperformance and defend its sovereign bonds from speculative attacks. But the recent political turmoil risks jeopardising this favourable course of action. Clearly, the events of these days are not bringing any favour to the count.

by Brunello Rosa

11 July 2022

Last week’s news extensively reported on Boris Johnson’s resignation as leader of the UK Conservative party. Johnson said that he will remain Prime Minister (PM) until the Tory party identifies his successor, who (by way of the UK’s unwritten constitution) will also become Britain’s new PM. In theory, this will happen by the time of the Tory party conference, which is scheduled to take place in Birmingham between October 2nd and 5th 2022. But the Labour and SNP opposition may push a confidence vote through parliament in order to speed up the substitution process. We suspect however that the conservative MPs will manage to avoid that; Johnson’s resounding victory in December 2019 gave the Tories their largest parliamentary majority since 1987. 

The list of candidates vying to succeed Boris Johnson is a long one. The first to present his candidacy was Rishi Sunak, the former Chancellor of the Exchequer. His and Sajid Javid’s resignations triggered the collapse of Johnson’s government, and he is probably one of the most credible candidates alongside Ben Wallace, the Defence Minister, who is reportedly loved by the party base (but Wallace rule out his candidacy). Other competitors are Sajid Javid himself, the former Health Minister, who will run together with Jeremy Hunt(who was defeated by Johnson in the last leadership race) and Liz Truss, the incumbent Foreign Minister. Inevitably, other names will appear on the horizon as we approach the party conference.

Boris Johnson’s legacy will be that of leaving behind a divided country, politically and geographically. His main success might have been that of “Getting Brexit Done”, but this has also meant shovelling Brexit down the throat of two nations that voted against it, i.e. Northern Ireland (NI) and Scotland. As a result, Scotland has already started the process to hold another referendum for independence, after the one narrowly lost by the secessionists in 2014.

Northern Ireland meanwhile is constantly on the verge of a crisis, as the UK government has suggested the repeal of the so-called NI Protocol, which regulates the commercial relationships with the EU in the region (which imply customs check in the British Sea, to keep the border between Northern Ireland and the Republic of Ireland open). Additionally, the victory by the Sinn Féin in the recent elections in Northern Ireland has made a referendum on the reunification of the Irish island much more likely in coming years.

The Brexiter dream of launching a “Global Britain” after the UK’s divorce from the EU may ultimately lead to a return of the “little England” of the 1970s, facing the economic consequences of its departure from the bloc: endemic strikes, high inflation, slow growth, and increasing difficulties in remaining part of global supply chains (which are themselves in the process of becoming balkanised).

The task of the next UK PM, whoever that will be, and whenever he or she will enter office, will be that of “Making Brexit Work” for the UK: making sure that the country can reap the benefits of the regulatory divergence that it has fought so hard to achieve. Part of the task will also be re-building a relationship with the EU, which ought to be less fractious than the current relationship has been. The risk of not doing so would be to end up leading a country with much less influence on the world stage.

by Brunello Rosa

4 July 2022

Last week, a G7 meeting took place in Germany. According to its final communique, the meeting of these seven developed nations sent “a signal of clarity and strength” on crucial matters such as the war in Ukraine, world hunger, and other key long-term risks such as climate change. German Federal Chancellor Olaf Scholz stressed that “what unites [the G7 nations is their] shared values: democracy, human rights, peace and freedom.” For this reason, the G7 countries invited to the party “partner countries” such as “Argentina, India, Indonesia, Senegal and South Africa.” 

As we discussed in our recent analysis, with the war in Ukraine, global governance has collapsed. The UN Security Council is balkanised like the rest of the world, with the US, UK and France on one side and Russia and China on the other side. Equally, the G20 is divided between supporters of the US and the West and those more inclined towards China and Russia (though there are a bunch of countries that would prefer not to take sides). For this reason, the G7 countries invited other partners from the developing world.

The G7 countries have also pledged to raise USD 600 billion in private and public funds over five years to finance needed infrastructure in emerging markets to counter China's multitrillion-dollar Belt and Road Initiative (BRI), in a newly renamed project called "Partnership for Global Infrastructure and Investment." If the extension takes place and gets implemented, this would amount to a new G7 gathering for developing economies, led by China. It would include countries with the largest populations in the world, and the largest natural resources reserves. With China’s BRI, which dates back to 2013, this new “EMG7” would have the firepower to compete on the international stage with the “traditional” G7.

Meanwhile, Russia has recently held its International Economic Forum of St. Petersburg, this year marking its 25th year. While one could think that, with the war in Ukraine, most world leaders would have deserted the forum and exposed Russia’s isolation, the Forum actually featured 13,500 participants from 141 countries and territories, with 43 foreign ministers and 1,500 companies represented at an executive level. At the forum, China, Russia and India discussed energy, supply and logistical corridors; the settlement of natural resources trading in currencies other than the dollar; the integration of the Eurasian geopolitical bloc with the Asian bloc; and even potential commercial agreements being reached between Pakistan and India. 

Given this background, it is clear that a new model of global governance is emerging: one based on NATO and the traditional G7 to take care of the developed world, another based on the new EMG7 gathering, China’s BRI, and the military alliances that are being forged, which will primarily focus on developing countries. We could summarise this by calling it a “balkanised global governance for a polarised world.”

While all this is happening, China and Russia are not just staying put. Instead, on May 27 the Foreign Ministers of the BRICS forum countries (Brazil, Russia, India, China, and South Africa) “reached consensus on its expansion process”, so as to potentially include Saudi Arabia and Argentina in this group of countries in the future. 

by Brunello Rosa

27 June 2022

After the French parliamentary elections that were held on June 12th and 19th, we are taking final stock of the long electoral cycle that took place over the past 2 years across the three major EU countries, Germany, France, and Italy. We previously carried out a similar exercise after the French presidential election took place, with our column on 9th of May 2022, but at that time the country’s parliamentary elections still lay ahead. We said then how Europe’s long electoral cycle, which started with the German general election in September 2021, followed by the Italian presidential election in January 2022 and the French presidential election in April 2022, had so far delivered a mixed result regarding the process of European integration. 

We said then: “The results of this round of critical EU elections, which will finish this June with the parliamentary elections in France, has been something of a mixed bag thus far. On the one hand, traditional pro-European parties have “held the fort”, so to speak. On the other hand, this “fort” remains under the siege of the anti-European parties, which may want to stop the integration process, or even reverse it. A few years of high inflation, higher interest rates, low economic growth or recessions may change the tide in favour of these still-strong populist parties.”

The French parliamentary elections have now delivered a blow to the EU integration process, at the “last curve” of this electoral cycle. As we discussed in our Viewsletter last week, Macron’s party won 245 seats (vs 289 needed for a majority), Mélanchon’s left-wing coalition NUPES won 131, Le Pen’s party got 89 seats and the Republicans got 61. All other parties combined won 51 of the seats. 

These electoral results meant that Macron only had two options. Either he could try to form a coalition with the Republicans in order to have a stable majority in parliament, or else he will have to seek a different majority for each law that will need to be passed by parliament. 

After the first round of consultations, it seems that the first route is difficult to implement, as Christian Jacob - the head of the Republican party - said that he wants the party to remain in opposition. But finding a majority with “variable geometries” for each new piece of legislation will also be complicated – it means that the President may have a very difficult time translating his agenda into law. 

The French constitution allows an extensive use of the confidence vote (article 49.3) to allow the government and the president to get his or her agenda through parliament. Still, without a solid majority, it is a very risky strategy to forgo a coalition. Alternatively, the President may dissolve parliament in coming years, but this may also result in a further erosion of Macron’s parliamentary support, in favour of the far-right, the far-left and the moderate right. So, Macron will have to thread very carefully in coming months and years. 

More so than the domestic agenda, such as the long-waited reform of the pension system, which will suffer, the advancement of the EU integration process is at risk. Macron has clearly been the stronger voice against Russia within the EU, but also with Russia (given his communication channel with Russian President Vladimir Putin) in the Ukrainian war. And he was speaking as the de-facto leader of Europe. A weaker French president will not be able to play the same role as convincingly. 

Any chance of further EU integration will also necessarily be impacted. We have already seen in the past that when France is against further integration, as for example was the case with the referendum on the EU Constitution in 2005, the process collapses. With almost 90 MPs, Le Pen can now credibly say that she is not representing a fringe movement anymore, but rather is reflecting the needs and desires of a large component of the French electorate.

by Brunello Rosa

20 June 2022

All of the largest and most influential central banks in the world held their policy meetings in the last couple of weeks. The US Federal Reserve adopted the largest increase in its policy rate since 1994 last week, with a 75bps increase taking its Fed funds target range up to 1.50-1.75%. Until a couple of days before the meeting, the Fed seemed to be excluding such a possibility. But then the May inflation figures, showing CPI at 8.6%, a 40-year high, convinced the Fed to adopt the emergency measure of increasing its target range so quickly (as did the inflation expectations gauge measured by the University of Michigan survey, which showed the potential of an initial de-anchoring). This move by the Fed may be replicated in July, if inflation prints do not start to convincingly and steadily decrease. 

Also last week, the Bank of England increased its Bank Rate by 25bps to 1.25%, marking the fifth consecutive rise since December 2019. Again, the choice was motivated by the latest figures on inflation, showing an increase in CPI by 9% y/y in May. Three out of 9 Monetary Policy Committee members would have preferred a larger increase in policy rates, of 50bps to 1.50%. But the majority of the MPC preferred a more cautious approach, given the risk of recession highlighted in last month’s Monetary Policy Report. Similarly, the Swiss National Bank (SNB) increased its policy rate by 50bps, to -25bps; a surprise move, marking the first rate increase in 15 years. The SNB feared a de-anchoring of inflation expectations, even if that meant a temporary strengthening of the CHF.

To conclude the week, the Bank of Japan went in the opposite direction, and left its policy stance unchanged, undeterred by the peer pressure. In effect, Japan faces a different combination of impacts from the war in Ukraine and the pandemic on its growth and inflation outlook, and can afford to keep its policy stance much looser than other major central banks.

Finally, the ECB held an unscheduled policy meeting on Wednesday, which followed the regular meeting in June that clearly left the market unsatisfied. On June 9th, the ECB announced two rate increases in July and September, to combat inflation. But kept its “constructive ambiguity” on what it would be prepared to do in case fragmentation in the transmission mechanism of monetary policy were to emerge. Following the meeting, intra-EMU spreads rose again, with the BTP/Bund spread at 10y maturity reaching levels (above 200bps) last seen in 2018-19 during the Conte 1 government, supported by the euro-sceptical majority Lega–M5S coalition. 

During the emergency meeting, the ECB’s Governing Council decided to task the relevant Committees with finalising the design and implementation of a new facility specifically aimed at reducing the fragmentation of the transmission mechanism (and therefore the intra-EMU spreads). In our preview, we mentioned how we thought that the “constructive ambiguity” approach was certainly insufficient to prevent the market from testing the ECB’s anti-spread resolve, and that a much more explicit reference to a facility explicitly aimed at reducing the market fragmentation was needed. The ECB thought initially that they could do without it, but then had to capitulate under the pressure of the market. In July they will probably reveal what this facility is about.

by Brunello Rosa

13 June 2022

Last week, Money 20/20, the largest FinTech conference in Europe, was held in Amsterdam. One of the headline events at the conference was a panel discussion in which the projectcalled a “New Era for Money” was presented. The project aims at developing and implementing the first Digital Sterling (dSterling) pilot. As we discussed on our website, Project New Era is a privately-led initiative evaluating the path towards a retail Central Bank Digital Currency (CBDC) in the UK. A CBDC would be the digital version of a banknote, with still the liability of a central bank. The project proposes that there be closer public-private collaboration in order to address key challenges and open questions relating to CBDC development.

Project New Era will form the Digital Financial Market Infrastructure (FMI) Consortium, with the aim of keeping central banks, regulators, and government informed of progress. The consortium will issue Sterling, a digital settlement asset similar to a CBDC, to drive the pilot, which will focus on core design issues. Rosa & Roubini Associates are an independent advisor of the Project and the associated Consortium.

The panel discussion in Amsterdam brought to the fore the technical, regulatory, policy and political challenges that lie ahead for the formal introduction of a CBDC in the UK. They mirror the challenges faced by all private and public sector actors in other jurisdictions on the introduction of a CBDC. In future reports we may discuss all this in more detail. In this column, we want to highlight one specific aspect of the adoption process: the reluctance felt by so many central banks in even engaging with the issue. 

Just to give an example, the Reserve Bank of Australia (RBA), in September 2020 declared that “the Bank's view is that there is currently no strong public policy case to introduce a CBDC for retail use,” for various reasons including the still-strong demand for AUD banknotes, the availability of an electronic payments system and the cost of the exercise. Since then, the RBA has introduced a number of projects to study the potential adoption of a retail CBDC, but officially their position has not changed. 

It is estimated however that around 80% of central banks are studying the introduction of a CBDC, and some of them have already begun issuing it. First and foremost, the People’s Bank of China (PBoC), which issued its e-CNY on the occasion of the Winter Olympics in Beijing. After this event, the US Federal Reserve speeded up its project for the introduction of a digital dollar in the US, following President Biden’s executive order on a Responsible Development of Digital Assets on March 9th. In particular, Rep. Lynch introduced legislation to develop an electronic version of the U.S. Dollar, in a pilot program. 

In the UK, there seems to be a gap between what the Treasury wants to do, namely to make the UK become a global hub for crypto assets, and what the Bank of England is prepared to do. The BoE’s approach seems more cautious than that of the Treasury, at this stage. In Europe, while the Riksbank is in the forefront for the introduction of its e-Krona, the ECB has just launched a 2-year investigation period for its own CBDC. 

Several industries have of coure already been disrupted by the introduction of digitalisation. We used to write letters, now we write e-mails; instead of phone calls on a landline, we now make video-calls on mobile phones. In the digital era, in which payments are made electronically and new forms of digital payments are introduced through crypto-assets and stablecoins, central banks will have to introduce the digital version of coins and banknotes, i.e. CBDCs. The PBoC has understood this before anyone else. It started its projects in 2014, and has already issued its digital renminbi. By doing so, it is gaining a massive competitive advantage on other central banks, including from a geopolitical perspective. So, the sooner reluctant central banks will realise introducing CBDCs is an inevitable process, the better. 

Put in simpler terms, regarding CBDCs, it's not a question of IF, but of WHEN, and maybe, HOW.

by Brunello Rosa

6 June 2022

Press reports inspired by conversations with Chinese officials emerged last week, indicating that Russian officials were “increasingly frustrated” because China was not offering the type of support they had been expecting to receive from their powerful new ally. As a result, discussions between the two sides have been “tense” recently. In particular, China has reportedly not be offering the military support that Russia was looking for. This is somewhat confirmed by the words of the US secretary of state Antony Blinken, who said that the US has not seen “a systematic effort” by China to help Russia evade sanctions, nor any significant military support from China to Russia.

Theoretically, China could buy some of Russia’s USD 130bn holdings of gold held by Russia’s central bank, and pay for it in US dollars. It could reactivate a currency swap line which was established after Russia’s annexation of Crimea in 2014, and it could serve as a lender of last resort to Russia. China could increase its purchases of natural resources from Russia (primarily oil, gas and industrial metals), or buy shares in some of Russia’s critical state-owned enterprises. China has in the past helped Iran to evade some of the US’ sanctions by using some of its smaller banks. In our recent column, we said that China could offer, and likely has offered, Russia use of its international cross-border payment system (CIPS), instead of SWIFT, from which it has been banned by Western countries.

This bout of frustration for Russia may come as surprise news in the same weeks in which Russia and China, through the respective Foreign Ministers Wang Yi and Sergei Lavrov, pledged to continue working together to establish “true democracy in the world, based on countries’ own conditions.”This declaration of intent is the logical follow up to the solemn joint statement made by Xi and Putin on February 4th, which began with the surprising sentence (for two autocratic leaders) that “democracy is a universal human value, rather than a privilege of a limited number of States, and that its promotion and protection is a common responsibility of the entire world community.” There is clearly an attempt by Russia and China to re-define what democracy is. 

While these developments are obviously puzzling, we are not surprised by this apparent contradiction for several reasons. 

First, China does not want to end up being caught by the US sanctions against Russia, which as usual carry a great deal of extraterritoriality. The US and Europe combined are still the destination for around 35% of Chinese exports, at a time when domestic growth in China is severely impacted by a) the lockdown imposed as a result of the zero-Covid policy; and b) the effects of the campaigns against tech companies, private education, and real estate developers, among others. So, China cannot really afford to substitute two of its largest trading partners with a small and declining economy such as Russia.

Second, we have already questioned the rationality of Xi’s decision to choose Russia as its ally in Cold War II against the US, considering how unpredictable Putin is, especially if he really is being affected by serious diseases, as some reports suggest. Unsurprisingly, now reports are starting to be published questioning Xi’s physical and mental health, and his fitness for the top job. They are published by Chinese sources, however credible, living abroad and anonymously republished in mainland Chinai mainland China.

Third, we must take into account the ongoing power struggle in China ahead of this autumn’s congress of the Chinese Communist Party, which will choose the Party’s official leadership, with Xi running for a third mandate in the first official step of establishing himself as leader of the country for life. If this happens, this would mark the interruption of the mechanism adopted since the 1980s to choose the country’s leader, in which the president and prime minister serve only two five-year terms (with the prime minister then touted to succeed the president at the end of his second mandate). Numerous reports suggest that Premier Li Keqiang could be getting ready to succeed Xi later this year, by capitalising on the widespread discontent caused by Xi’s anti-graft and Zero-Covid campaigns, which have - according to Li - greatly damaged the economy (which he is officially responsible for). So, Xi needs to show that his choices are still rational and not dictated by the needs of Putin, whose judgment abilities may be compromised.

All this suggest that the first cracks may start emerging in the new alliance between China and Russia, which was in effect supposed to be limitless. The front of the two autocracies within the UN Security Council may not be as united as Xi purported it was when he called US President Biden to congratulate him for his victory in 2020. On that occasion, Xi reportedly told Biden that “autocracies, not democracies, will run the world in coming decades,” as in an increasingly complex world in rapid evolution, quick responses were needed. But “democracies require consensus and consensus takes time to build, but countries have no time.” When reporting on the content of his conversation with Xi, Biden concluded that Xi was “wrong.” Perhaps these recent tensions between China and Russia prove that democracies will be able to survive as an effective way of governing for a bit longer

by Brunello Rosa

30 May 2022

Oil prices have risen substantially in the last couple of years. In April 2020, at the beginning of the pandemic, Brent crude oil was trading just above USD 20pb (after having dropped briefly into negative territory, as the price of storage soared as a result of widespread lockdowns that prevented super-tankers from docking in ports). Currently oil prices are trading well above USD 110pb, as a result of the reopening of economies and, especially, the war in Ukraine and the further disruption in global supply chains. Lockdowns in China, commanded by the ill-conceived Zero-Covid policy, have disrupted the port of Shanghai, and are making the situation worse.  

For gas prices the situation is similar. The US liquefied natural gas exports price is currently trading at 10.17 USD per thousand cubic feet, up from 8.56 last month and 6.52 one year ago. This is a change of 18.81% from last month and 55.98% from last year. According to the EAI, natural gas spot prices are rising at most locations. The Henry Hub spot price for example rose to $9.30 per million British thermal units (MMBtu) last week, from $8.45 the previous week. These increases are completely attributable to the war in Ukraine, as gas had continued to circulate freely during the pandemic. 

The negative supply-side shock represented by the massive increase in energy prices discussed above will have its traditional impact on the economy: it will reduce economic activity while increasing price inflation. This will be felt more strongly by those countries more dependent on energy imports, such as Eurozone countries, with Germany and Italy the most reliant on Russian gas imports. Various national governments have tried to reduce the impact on households and companies with tax rebates and the freezing of fuel duties. But at EU-wide level, a different solution is emerging. 

In Brussels, there are two lines of thought regarding this subject. One is that there should be an embargo on oil and gas imported from Russia. The other is that there should be a price cap; a limit  on the amount the EU can spend on oil and gas imports. So far, the idea of the embargo is having the upper hand in the discussion, as politicians believe it is the quickest way to stop financing Putin’s regime and its war in Ukraine. But there is another reason why the Europeans prefer the solution of the embargo to that of the price cap. 

The price cap solution was suggested to the Europeans by the US Secretary to the Treasury Janet Yellen, on at least two occasions (the latter occasion being the G7 meeting in Germany on May 18-20). 

The proposal was to set a price limit to how much the EU would be willing to spend for oil and gas (a price cap), and the US would help enforce the cap by applying itself to its own trades. Also it would ask all its trade partners to help enforce the cap, in an extraordinary example of extra-territorial coordination of policies and sanctions. 

Facing this generous offer, the Europeans preferred to opt for the embargo, to show some form of strategic autonomy from the US. In doing so, they choose an illogical solution from an economic standpoint. The embargo will reduce the quantity of energy in circulation and will increase oil and gas prices, as the Europeans will be forced to make agreements with other sellers. Conversely, the price cap would have kept the same amount of energy at Europe’s disposal, at a reduced price. 

A third possibility that has been flagged recently is a sort of “punitive EU tariff on Russian oil, proposed by the US and others,” which would pave the way to an oil embargo at a later stage. According to its proponents an EU-wide tariff on Russian oil would “compel buyers to demand an offsetting discount from Russian sellers, cutting Moscow’s profit, or go elsewhere. A tariff that successfully forced Russia to cut prices would in effect transfer tax revenues from Moscow’s coffers to the EU’s.”

Regarding Europe’s strategic autonomy, the EU may decide not to follow the lead of the US on the price cap, but it will eventually be forced to follow the US lead on military strategy, which – as we discussed in previous columns – diverges from that of the Europeans, insofar as the US will want to continue the war for longer, whereas the Europeans are aiming at an immediate ceasefire, at almost any cost. 

For the US, the war has produced the following tangible results: it has re-aligned its historical and potentially reluctant allies; it has induced the Europeans to contribute more to the NATO budget (a long-standing request by the US); it has led to an increase of NATO membership (with Finland and Sweden likely joining); and it has implied that the US will start exporting its energy (in particular LNG) to Europe. The Europeans, on the other hand, have a lot to lose from a continuation of the war, as they are the most exposed to the sanctions, and to the “collateral effects” of the war, such as the rise in refugees. Since the war has polarised the world, the dream of the European strategic autonomy by way of the EU, or even of a European neutrality between US and China, has clearly vanish.

by Brunello Rosa

23 May 2022

As we discussed in last week’s column, markets are in turmoil as recession fears increase around the globe. Central banks had thought that inflation would be a temporary phenomenon due to transitory factors, but instead it proved to be a persistent feature of the post-pandemic world, exacerbated by additional supply-chain constraints and the rise in energy prices due to the war in Ukraine. As a result, they have all turned hawkish (with a few exceptions, such as the BOJ) and started policy normalisation programs. 

Now central banks are assuring the public that a recession will not take place as a result of the series of shocks that have hit the global economy, but they are also warning that they cannot guarantee a “soft landing” will take place. Hence the market now fears that a recession may in fact occur at some point in 2022. This is causing a free fall in equity indices, with the S&P now exhibiting the worst start to a year since 1939, entering a bear market. It is also causing a fall in long-term bond yields. As we discussed last week, this can be interpreted as the market fearing an outright recession more than a stagflationary shock, as the contraction in economic activity would tame inflation somewhat by reducing aggregate demand. 

A combination of lower risky asset prices, economic deceleration and rising recession fears may induce central banks to adopt less aggressive policy normalisation plans than initially anticipated. At the same time, their normalising rates and withdrawing liquidity at the time the economy is wobbly may be a very risky strategy, especially at a time when governments are also considering fiscal consolidation plans. For example, the final communique of the G7 meeting held in Germany at the end of last week, under German leadership and presided over by the German Finance Minister Lindner, called for a reduction of the debt that states had accumulated to fight the pandemic. 

This combination of higher inflation and policy interest rates, reduced economic growth (or even recession), high public indebtedness and reduced central bank liquidity could be particularly dangerous for the most fragile countries. 

In the Eurozone, for example, Italy has already witnessed a sizeable increase in its yield spreads versus Germany in the last few weeks (with the 10y yield spread having surpassed 200bps), a larger widening than that experienced by similar countries such as Portugal and Spain. 

In September 2019, while the Fed was implementing its first round of Quantitative Tightening (QT), at some point the reduction in liquidity proved excessive. As a result, the US Treasury market became really unstable, with long-term treasury yields spiking. The Fed had no other option than interrupting its QT program and re-starting asset purchases again (in this case, for the smooth functioning of the transmission mechanism of monetary policy). 

This may happen again in the US and in other jurisdictions, chiefly in the UK and in the Eurozone. In particular, in the Eurozone, the ECB has not specified whether a new facility to keep the intra-EMU spreads will be launched at the time QT is announced. For now, the ECB prefers to continue to keep some form of “constructive ambiguity” regarding this choice, preferring to say that, at the right time, the ECB is ready to re-start the Pandemic Emergency Purchasing Program (PEPP), or to use its re-investment policy to keep the spreads in check, or to come up quickly with a new facility. This choice is also motivated by the decision to avoid any legal challenge related to the adoption of a new instrument by the Governing Council.

Some analysts suggest that a new version of the Outright Monetary Transactions (OMT, with lighter conditionality) may be used in this case. But the positions within the Governing Council clearly differ. However, time is running out. If the ECB intends to end its net asset purchases in June and start increasing rates in July, when market liquidity will be further reduced by the summer season, one cannot rule out a market accident involving the most indebted and more fragile countries such as Italy. So, it may be preferable for the ECB to specify what it intends to do in case an unwarranted increase in spreads occurs, instead of rushing to find a solution after a market accident has already occurred.

by Brunello Rosa

16 May 2022

Last week, financial markets were in turmoil once again. Global equities decreased on a weekly basis, with the MSCI ACWI index down by -2.2%, the US S&P 500 index dropping -2.4% and the MSCI EMs falling by 2.6%. With this week’s negative performance, this year is the second worst start to a year for the S&P 500 in history: -17.5% in the first 91 trading days. Logically, volatility has also risen considerably, with VIX rising to 29.35 (versus a 52-week average of 21.7 and a 10y average of 18.0). 

Volatility in markets is increasing as investors are becoming sceptical that central banks will be able to engineer a ‘soft landing’ for the economy after the series of rate increases that they are planning to implement in coming months in order to tame inflation. Reasons for concern abound, as investors have suffered from: i) the accelerated pace of monetary tightening that most central banks have announced, most recently the ECB, which may be increasing rates already in July; ii) geopolitical news, with Russia threatening a retaliation to a possible admission of Finland and Sweden to NATO; iii) persistently high inflation data; iv) the impact of strict lockdowns in China, which are further disrupting global value chains; and v) increasing recession fears as the global economy is slowing down. 

However, last week, something different from previous weeks occurred. US government bond yields (especially in the US and the eurozone) fell amid the sell-off in equity prices. So, the correlation between bond and stock prices went back to negative after being positive recently. Finally, credit spreads widened, with the effective yield on US “junk bonds” (US High Yield Master II) reaching 7.4%, the highest level since May 2020. All this while bank equity prices continue to fall, with the shares of the five largest US banks down between 20% and 25% year-to-date.  

How can we interpret all this? In the stagflationary scenario that we have observed so far, the combination of higher inflation, lower growth and higher long-term rates, have led to a parallel decrease of bonds and equity prices (positive correlation). But the increase in recession probability means that inflation may be lowered by the reduction of the demand side of the economy, making stagflation fears less pressing. As a result, there start to be risk-off flows into government bonds, thus lowering their yields. 

Additionally, rate increases tend to be good for banks, as they steepen the yield curve on which they profit with maturity transformation. But if rate increases risk causing a recession, the weakening of the economy would be bad for bank profitability. As a result, bank equity prices fall. 

In all this, price movements have been exacerbated by the sharp sell-off in the crypto-currency space, where Bitcoin has fallen below the psychological barrier of 30,000 and lots of stablecoins went under stress, with the Terra/Luna trade collapsing and even Tether shortly falling to 95.11 cents on the dollar. With USD 80bn held in assets as collateral, sharp liquidations to keep the peg at 1$ would eventually also impact traditional markets, not just the USD 1.3tn crypto-asset market.

by Brunello Rosa

9 May 2022

In February 2019 we identified the round of elections taking place between the German general election in September 2021 and the French parliamentary election in June 2022 as being crucial to determining the future of the EU integration process. Now, as we approach the end of this round of elections, we want to take stock of what has happened thus far, to revisit our earlier views on the subject.

The German general election (September 2021). The German election resulted in a collapse of the CDU. The CDU was narrowly overtaken by the SPD, which was able to form an unconventional “traffic light” coalition with the Greens and the Liberals. So far, this coalition has managed to navigate both the last phase of the pandemic and the war in Ukraine with relative tranquillity. The pro- European and Atlantic credentials of Germany have been re-affirmed, and the extreme wings of Germany’s political spectrum have been left out of government. However, the fragmentation of the political system, with the collapse of traditional parties, is not reassuring for the stability of Germany, the key pillar of the EU and Eurozone.