WEEKLY COLUMNS (ARCHIVE)

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by Brunello Rosa

18 February 2019  

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

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

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

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

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

Picture from the “Populism Research Group” at Loughborough University 

by Brunello Rosa

11 February 2019

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

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

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

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

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

by Brunello Rosa

4 February 2019  

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

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

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

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

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

by Brunello Rosa

28 January 2019  

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

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

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

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

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

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

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

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

by Brunello Rosa

24 December 2018  

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

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

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

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

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

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

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

by Brunello Rosa

17 December 2018  

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

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

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

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

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

 (Picture by Associated Press, from www.ilsole24ore.com)

by Brunello Rosa

10 December 2018  

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

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

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

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

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

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

by Brunello Rosa

3 December 2018

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

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

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

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

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

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

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

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

by Brunello Rosa

29 October 2018

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

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

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

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

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

by Bruello Rosa

22 October 2018

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

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

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

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

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

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

by Brunello Rosa

15 October 2018

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

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

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

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

by Brunello Rosa

8 October 2018

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

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

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

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

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

by Brunello Rosa

3 September 2018

This week, following US Labor Day on Monday September 3rd, the holiday season will be over. The return to work will be accompanied by several events that indicate the possibility of a high and imminent level of risk existing in a number of developed economies (DMs) and emerging markets (DMs). 

Starting with DMs, Brexit negotiations will enter their final stage in the coming days for a deal that needs to be struck by the end of September in order to be brought to the EU Council for approval on October 10th. This will occur just after the annual Tory party conference, which will be held in Birmingham between September 30th and October 3rd. This will be the last chance for the Conservatives to find a common position and present a united front in final rush to conclude the Brexit negotiations. The risk of a no-deal Brexit outcome is increasing, but at the same time, the chief EU negotiator said that the Commission might be prepared to offer an arrangement that has never been given to other countries before, rather than continue to stick to the dichotomy of the Canada/Norway models that has dominated the negotiations thus far. The GBP has been quite sensitive to this news, and has recovered somewhat of late versus the EUR and the USD. 

Further south, Italy is about to enter its month of passion, with the Document of Economic and Finance (DEF) Update set to be approved by Parliament by September 27th. The market is eagerly awaiting the number that Finance Minister Giovanni Tria will designate for Italy’s budget deficit in 2019, which will be compared with the 0.9% level previously agreed upon with the EU. The new level will certainly be higher than 0.9%, but will it be also higher than Italy’s current budget deficit level of 1.8%? If it is set higher than 1.8%, that would likely signal the interruption of Italy’s convergence towards the Medium-Term Objective of a balanced structural budget.   

Indeed, market participants are widely expected to start a speculative attack against Italy’s public debt and banking system, with rating agencies getting ready to downgrade the country’s creditworthiness, potentially leading to the collapse of the newly formed populist government. This could, in the medium-term, lead to a Eurozone break-up. In a recent report, we discuss how to hedge against that risk. 

Moving to the EM space, the Turkish crisis that has dominated August has subsided since the TRY has stabilised thanks to the central bank “stealth” increase in interest rates. The underlying issue has not been resolved, however. More decisive actions will need to be taken by Erdogan to end the crisis and avoid a collapse of the newly formed presidential regime. The government will try to continue avoiding asking for IMF assistance, which is considered politically toxic in Ankara given the relationship between Trump and Erdogan. 

In contrast, Argentina has been desperately asking the IMF to speed up its intervention; Argentina’s central bank was forced to increase its interest rates by further 15% to 60% last week to stem the peso’s depreciation. USD/ARS reached the record high of 38.7 (with intraday beyond 42) as investors continue to steer away from Argentina’s bonds and currency. The actively risky situations in Argentina and Turkey are at risk of involving other emerging markets as well, as we have discussed in previous reports and will analyse further in an upcoming paper. The presidential elections on October 7th in Brazil might offer further scope for such EM contagion. 

In conclusion, market participants have hopefully gotten plenty of rest during the summer, as the autumn will probably prove to be extremely bumpy, and is likely to bring a number of sleepless nights.

by Brunello Rosa

28 August 2018

The S&P500 index rose by 0.9% last week, reaching an all-time high of 2,874.7 points. The VIX index declined by 0.6 points, to 12; it is now well below its 52-week average of 13.6 and its 10-year average of 19.5. A high level of economic activity is underpinning this strong performance in U.S. equity markets. A 4% annualised rate of GDP growth in Q2 of 4% is expected to be confirmed this week. The US unemployment rate is near its historic lows, at 3.9%. Inflation also remains well behaved: this week core PCE is expected to be confirmed to have remained at the Fed’s target level of 2%. 

Developments in other financial markets are helping too. The long end of the US yield curve remains low despite strong growth and rising inflation; the 10y yield is still below the crucial 3% threshold level. This confirms what we discussed at length in a recent report on US fixed income; namely, that the flattening US yield curve (the 2y10y yield spread recently reached 21bps, the lowest level in more than a decade) does not necessarily indicate that of a recession is imminent. 

In FX markets, the USD depreciated against a basket of currencies last week. The dollar index DXY fell by 0.7%. This fall also helped US equity valuations. Some commentators have attributed this (temporary?) interruption to the USD rally to President Trump’s criticism of the Fed’s policy tightening. There might be an element of truth to this view; that said, Fed chairman Jay Powell, in his inaugural speech at Jackson Hole’s annual symposium of central bankers last week, reaffirmed the current Fed’s policy of gradually tightening policy rates. The Fed continues to foresee two more rate hikes in 2018 and three in 2019.  

US financial markets are being buffeted but not shaken by the political and geopolitical risks the US is facing (or, in some cases, has actively been working to create). Investigation into "Russia-gate" are increasingly focusing on the President’s inner circle, but they do not necessarily seem to be leading towards impeachment. Indeed, the probability of impeachment will decline if the Democrats do not manage to win at least one of the two houses of Congress in November. Meanwhile, negotiations on NAFTA had seemed destined to fail until a recent breakthrough with Mexico re-opened the possibility of a positive conclusion being reached. Trade tensions with China, though they are still escalating, do not necessarily seem to be leading to a full-blown trade war. Even Trump's recent spat with Turkey’s President Erdogan seems to be only a small political skirmish in the grand scheme of things. 

The US performance is broadly in line with our strategic asset allocation (which will be updated in September), which still foresees a skew towards equities and some cautious risk taking. The US performance also remains in line with our analysis following the stock market fall in early February, when we warned that volatility and inflation fears would likely continue to weigh on markets. Indeed, it took a full seven months to recover the equity valuation highs that had been reached on January 26th. 

At this point, we continue to suggest caution. The factors that could lead to further stock market rises in the US might be countered by increasing fragilities in the world economy, particularly in emerging markets, which have started feeling the pain of the Fed’s tightening and USD strength. Politics and geopolitics may also affect financial markets in unexpected ways, even if a U.S. equity bear market is not on our radar screen just yet.

by Brunello Rosa

6 August 2018

It’s August, schools are closed and some of our readers are probably enjoying well-deserved holidays. This year summer temperatures are warmer than usual, in many parts of the world. In Europe average temperatures are reportedly 6-12 degrees Celsius above normal seasonal averages, and have touched 40 degrees Celsius (104 Fahrenheit) in a number of countries, even in Northern Europe. These extreme weather conditions could make holidays more enjoyable for those spending time at beaches, lakes, or mountains, but on a larger scale they are unlikely to be good news. Because of the hot weather, forest fires have been raging in a number of places: California, Sweden, Britain, and Australia. In Greece, the fire that recently claimed more than 90 victims near Athens was partly caused by high temperatures and drought. 

Assuming that high temperatures are the result of climate change, their long-term implications are likely to be severe. In his seminal book Connectography, Paragh Khanna provided a picture of how the world might look at temperatures 4 degrees warmer than usual. Comparing that picture with maps showing present-day migration flows (maps from the International Organization for Migration, for example), one can already see astonishing similarities. People are leaving places of recent or impending desertification. As far as Europe is concerned, the largest places of origin for migrants are countries in the Sahel and Sub-Saharan Africa. This is because the Sahara Desert has expanded to the south, making living conditions in some areas (via agriculture, drinkable water, etc.) impossible. People from these regions try to reach Europe by crossing the Mediterranean, leaving Africa from countries such as Libya where border controls have been reduced by political weakness of public authorities.  

Political authorities in Europe, the US, and other parts of the world continue to make the distinction between a refugee (“someone who has been forced to flee his or her country because of persecution, war or violence”, according to UNHCR) and an economic migrant (“a person who leaves their home country to live in another country with better working or living conditions”, according to Cambridge Dictionary). Only the former is entitled to receive international protection by being granted asylum in recipient countries. 

There is an inconsistency here: people escaping declared and recognised wars are classified as refugees and are entitled to apply for asylum and remain in the countries they have arrived in, while those escaping an equally certain death due to incipient desertification are considered economic migrants and can be sent back to their countries of origin. In our opinion, this distinction is flawed and outdated. As Prof. Jeffrey Sachs wrote in a recent article, “we are all climate change refugees now.” As discussed in a recent book, because of the social and political implications of climate change and migrations, conflicts are also more likely to emerge in migrants’ countries of origin. 

Political authorities need to start acting in accordance with this new reality, since ignoring it only feeds populism. There are now tens of millions of internally-displaced people, refugees and “economic migrants.” They will all want a chance for a better (or any) life, and will go to the most advanced economies. In 2015, for example, Germany became the single largest recipient of new individual asylum claims globally, with 441,800 registered individuals. It became the second most common destination for international migrants globally, one spot behind the US and ahead of Russia. One can understand traditional or populist political parties being resistant to this new phenomenon, but that will not change the fact that it will become more evident in the years to come. According to Prof. Sachs, “there is still another 0.5º Celsius or so of warming to occur over the coming decades based on the current concentration of CO2”. The environmental effects of this have yet to be observed.

Climate change, to be sure, is not just an environmental phenomenon to be discussed in large international symposia. It is an emergency, with massive economic, social, and political ramifications that need to be tackled with the utmost determination and sense of urgency. Before it is too late.     

(Links to examples of fires this year were taken from Prof. Sach's article.) 

by Brunello Rosa

30 July 2018

While the independence of central banks starts to be questioned or, in some cases, openly challenged (as we discussed in last week’s column), central banks continue to do their job of trying to deliver price and wider macro-economic stability. 

Last week, the European Central Bank left its policy stance unchanged and did not provide further details of its future re-investment policy, which probably still needs to be agreed upon within the bank’s Governing Council. We will probably need to wait until after the summer break to know more about this crucial aspect of the ECB’s policy stance. 

In Turkey, the CBT unexpectedly kept its policy rate, the one-week repo rate, on hold at 17.75%. This decision surprised analysts and market participants, who had been looking for a 100bps increase in the repo rate. It therefore triggered currency outflows that weakened the TRY, with the USD/TRY rising by 1.2% over the week, to 4.852. The bank’s decision might be the first instance of Erdogan using his influence over the CBT’s policymaking now that his mandate has been renewed and reinforced as a result of the June 24th elections. 

On the other hand, press reports suggest the PBoC further eased its policy stance, reducing a specific capital requirement for local financial institutions in order to help them meet their credit demands more effectively. The PBoC easing is part of a wider strategy by the Chinese authorities to implement an expansionary monetary and fiscal stance to cushion the Chinese economy from the potential effects of the trade tensions deriving from commercial wars initiated by US President Trump. 

This week, three of the world’s major central banks will also hold policy meetings. On Tuesday, the Bank of Japan will conclude its two-day policy meeting and release the new bank’s forecasts. Press reports have been suggesting for days that the BoJ will change its policy stance, for example by dropping its Yield Curve Control policy. We don’t expect the BoJ to do so, as the inflation target is still too far from present rates for the central bank to tighten its stance (core-core inflation is still close to zero). 

On Wednesday, the Federal Reserve will hold its Federal Open Market Committee (FOMC) meeting, which is likely to be concluded with the Fed funds target range being left unchanged at 1.75%-2%. The bank’s formal statement following the meeting will be watched closely, as the FOMC will most likely prepare the ground for the further 25-bps increase in the policy rate to be implemented at the end of September. 

On Thursday, the Bank of England will hold its August MPC meeting and is expected to increase its Bank Rate by 25bps to 0.75%, in effect the first tightening of policy rates in a decade (the 25bps increase to 0.5% in November 2017 was merely a return to the effective lower bound, as estimated in 2008). The BoE has probably found a window in which to slot in a rate increase before the Brexit debate becomes even more heated this autumn. 

Central banks continue working to ensure that the transition of the real economy to levels consistent with its supply-side structure remains as smooth as possible. Hopefully they will be able to continue to do so in an independent and non-conditional manner in the years to come.

Read R&R Full Analysis Here

by Brunello Rosa

9 July 2018

Last week, the combination of the minutes of the Fed’s June FOMC meeting, the employment report on Friday 6th and continued trade tension (with the implementation of tariffs and counter-tariffs between US and China) had the usual flattening impact on the U.S. yield curve, with the 2/10y yield spread now just above 30bps, the lowest level for the last ten years. Mechanically, the twist of the yield curve is easy to understand. 

At the short end, a buoyant economy, boosted by a late-cycle fiscal stimulus, with a very tight labour market and rising salaries leading to above-target inflation (with the June figures to be released during this week) imply a central bank continuing its monetary policy normalisation for at least another 18-24 months, and this is reflected in a 2-year yield at its highest level since 2008. Upward pressure on short-term rates derive also from increased issuance of T-bills, to finance the larger budget deficit. 

At the longer end, international factors seem to be playing a larger role than domestic ones. As long as the ECB and the BoJ continue to conduct very accommodative monetary policies (they are both still increasing the absolute level of their balance sheets, albeit at a reduced pace) long-dated German bund yields will remain low in historical terms, and JGB yields near zero, given the BoJ’s Yield Curve Control policy. In fact, quantitative easing depresses the term premium embedded in long-term yields, which even in the U.S. (where the Fed is reducing its balance sheet and increasing rates), remain very low, if not negative. In such a context, international arbitrage continues to suggest investor to buy US Treasuries any time their yield (at 10y maturity, for example) approaches 3%, in spite of the appreciating dollar (and/or after having taken into account cross-currency hedging). Additionally, increasing trade tensions continue to suggest potentially lower growth potential in the medium term, adding downward pressure to the already low and diminishing real “global” long-term rate, with risk aversion pushing further the safe-haven bid for Treasuries. 

So, given the combination of macro-financial and geopolitical phenomena, it is absolutely natural that the U.S. yield curve flattens. The question is: does a flatter - or even inverted - yield curve, necessarily indicate an incoming recession (say, over a 12-month horizon) as the traditional literature suggests? In a speech of a few months ago, former New York Fed President Bill Dudley discussed the several reasons why this wasn’t the case. 

However, his successor John Williams, has more recently suggested that inverted yield curves are still a very powerful signal of incoming recessions. This seems to confirm a recent study by the Federal Reserve of San Francisco, concluding that “while the current environment is somewhat special—with low interest rates and risk premiums—the power of the term spread [i.e. the difference between long-term and short-term interest rates] to predict economic slowdowns appears intact.” On the back of this assumptions, the New York Fed continues to publish on a regular basis an estimate of the recession probability based on the slope of the yield curve. Based on the latest data, the probability of a recession in June 2019 would now be around 12.5%.

In our opinion, international factors play such a huge role on the shape of the U.S. yield curve that any estimate of a recession probability in the U.S. based solely on the U.S. term spread is likely to be largely overstated. On the other hand, it is quite likely that the cumulative effects of the Fed’s monetary policy normalisation (moving at some point into the neutral/restrictive territory) will eventually be felt by the economy, which will inevitably face a new contraction in coming years. 

by Brunello Rosa

2 July 2018

The results of the EU summit on June 28th-29th have been disappointing, as we predicted in our recent travel notes from Berlin. A lot of the media attention was focused on the discussion over migration, and the agreement reached seems insufficient for all sides. Merkel made bilateral agreements with Spain and Greece to allow a re-patriation of the migrants caught in Germany and first registered in those countries. Similar agreements have been discussed with other governments, but not from the Visegrad group. 

Additionally, Italy has not ratified any similar bilateral agreement (given the opposition of Interior Minister Salvini, also leader of the League), and this was the most important for Merkel to sign. More importantly, Germany’s Interior Minister, and leader of the CSU Horst Seehofer said that even if those agreements had been signed, they would not be as effective as his proposal of rejecting migrants engaging in “secondary movements” within the EU at the German border. This was a proposal that Merkel refused to accept, fearing a domino effect that would lead all European countries to close their borders, thus marking the end of Schengen but also of one of the four freedoms of Europe – that of free circulation. As a result, Seehofer has offered his resignations, which means that Germany’s government crisis is far from over and might actually intensify in coming days . 

On the Eurozone reform, vague language on the “beginning [of] political negotiations on the European Deposit Insurance Scheme” accompany the only tangible result, the agreement on the fact that the “ESM will provide the common backstop to the Single Resolution Fund (SRF).” All other elements supposed to be discussed, (Euro budget, macroeconomic stabilisation mechanism, European unemployment insurance scheme – presented in a letter by Eurogroup president Mario Centeno to Donald Tusk) have been postponed until December 2018.  On a side note, Greece eventually got the long-waited measures of debt relief that would allow a clean-ish exit from its third program of international financial assistance.  

Finally, on Brexit, as we anticipated, the Europeans could only welcome the “further progress made on parts of the legal text of the Withdrawal Agreement,” while expressing “concern that no substantial progress has yet been achieved on agreeing a backstop solution for Ireland/Northern Ireland,” and reiterating that “work must also be accelerated with a view to preparing a political declaration on the framework for the future relationship, [which] requires further clarity as well as realistic and workable proposals from the UK as regards its position on the future relationship.” Effectively the Europeans told the Brits to put their act together and make a decision on what kind of Brexit they want, at the same time warning all member states to be ready for any possible outcome (read: no-deal).

On the back of the considerations above, it is hard not to see an intensification of the European crisis (discussed in a previous column), which will eventually crystallise in one or more of the following ways: a German government collapse; a collision course between Italy and the market, possibly leading to a renewed Euro- or banking crisis; a political crisis in the UK following failed negotiations for an acceptable deal in October; an outbreak of populist parties in the many countries of Europe in which they are gaining power, and most likely in the European elections in 2019.   

These events are likely to induce increased volatility in FX rates (especially EUR/USD and GBP/EUR), in bond yields (in particular bunds and gilts) and eurozone peripheral spreads (chiefly the 10y BTP/bund yield spread). 

by Brunello Rosa

11 June 2018

Immediately after the disastrous conclusion of the G7 meeting in Canada (which we anticipated in last week’s column), and ahead of this week’s historical meeting between US President Donald Trump and North Korea’s leader Kim Jong-un, central banks return to centre stage, with the policy meetings of the US Federal Reserve, the ECB and the Bank of Japan. 

In line with consensus, we don’t expect any change in BOJ’s policy stance, especially after the Japanese economy contracted by 0.2% in Q1, and inflation has fallen back from the 1.5% yearly increase recorded in February to 0.6% recently. Following our recent analysis, and on the back of these data, we don’t expect the BOJ to make any significant change to its communication until March 2019 at least. Regarding the ECB, we expect the Governing Council to start its discussion on if and how to continue with its asset purchase program, but we don’t expect any major announcement to be made at this stage yet. The major obstacles to pre-commitments are the ongoing soft patch the EZ economy is experiencing and the resurgent political instability, following the formation of new governments in Spain and in Italy (on which we publish a working paper in bullet points). 

Regarding the Fed, in line with consensus, we expect a 25-bps increase in its Fed funds target range to 1.75-2.0%, while we don’t expect the dot plot to indicate four total hikes in 2018 yet. 

The key aspect of this policy meeting might be the repercussions that a further increase in US rates and strengthening of USD might have on emerging markets. As we discuss in greater detail in the section “The Quarter Ahead,” the recent increase in US policy rates, reduction in the Fed’s balance sheet and dollar appreciation are starting to generate significant outflows of funds from EMs, forcing some central banks to implement “defensive” rate hikes or FX interventions to defend the value of their currencies (with Brazil, Indonesia, Mexico and India having joined Turkey and Argentina). 

As discussed in a recent article for the FT by India’s central bank governor Urjit Patel, the combination of Fed’s balance sheet reduction and increased issuance of US Treasury bills and notes to finance the higher fiscal deficit due to Trump’s tax cuts, is creating a dollar shortage that is putting pressure on EM currencies (especially of the most fragile countries). Initially, the Fed might shrug off the effects of its policies on other countries, but eventually it might be forced to look back into it. If the dollar appreciates notably, its policy normalisation to control inflation dynamics might afford to be slower than otherwise. If the rest of the world goes into an economic slowdown as a result of localised (but numerous) currency crises, global growth will also slow down eventually, thus affecting the Fed’s policy path. It will be interesting to watch whether or not Jay Powell, in his press conference on Wednesday, will address this issue.

by Brunello Rosa

4 June 2018

This week the world’s seven most advanced economies will convene in Canada for their periodic G7 meeting. Not long ago, this reunion was called G8, as also Russia was participating (from 1997 to 2014, when it was excluded due to the Crimean annexation). In our recent trip report from Russia, we discuss how the series of sanctions that have hit Russia from 2014 onward has convinced its omnipotent President Putin to pursue more in-ward looking policies as opposed to the structural reforms suggested by his advisors, aimed at opening up the Russian economy and increasing its sluggish growth potential. However, the rise of autocratic, inward-looking, protectionist and sometimes nationalistic leaders (discussed in a previous column) is a widespread phenomenon, as testified by the upcoming presidential and parliamentary elections in Turkey (on June 24th), where President Erdoğan aims at further increasing its grip on the country, as discussed in our recent paper. 

In the US, the democratically elected President Trump is adopting an increasingly protectionist stance, as demonstrated by the decision to impose tariffs on US import of steel and aluminium from Mexico, Canada and the EU, after the exemption period expired this week. This comes at the time the US is already in a potential trade war with China and is re-negotiating NAFTA. At the G7 meeting of finance ministers and central bank governors, six countries asked US Treasury Secretary Steve Mnuchin to convey their "unanimous concern and disappointment" about the tariffs to the President. Somebody has already started to re-label next week’s G7 meeting as a G6+1. 

Is it the end of it?  Well, in Italy, the new Conte government has just been sworn in, supported by reportedly populist parties such as Five Star and League. For the time being, the EU has shown its friendly face to Italy, saying (with Juncker, Moscovici and Merkel) that European partners are ready to cooperate with the new Italian government. But what if Italy starts significantly drifting away from its traditional pro-European and pro-NATO stance? Will the G7 become G5+1+1? 

What about Germany? For the time being, as discussed in our recent trip report, the political system is trying to revitalise the centre ground, but – in case of failure – populist and extremist parties from the right and the left are ready to make significant electoral progress and render Germany as ungovernable as Italy is. Would that mean we are going to have a G4+1+1+1? Maybe, unless also the UK starts significantly deviating from its traditional free-trade policies by making the wrong customs arrangements, post-Brexit (as we discuss in our upcoming trip report); in which case we might have a G3+1+1+1+1. What if Macron fails to reform France and Abe manages to change the Japanese pacifist constitution? At that point, there wouldn’t be much left of the once seemingly invincible consensus of the world’s "most industrialised" nations. 

The reality is that the pendulum of history is swinging in a direction that is opposite to the one that led to the equilibria reached after World War II, and the formal and informal institutions that emerged from them. Physics tells us that, unless a lot of effort is made to stop its movement, the pendulum will continue to swing until the opposite (dis-)equilibrium is reached. 

by Brunello Rosa

29 May 2018  

We have discussed in a number of papers the various dimensions of the European political economy debate. From the prospects of further EU and EZ integration to the Brexit saga, from the Catalonia independence issue to Macron’s efforts to promote a faster unification process, from the rise of populist parties in Italy to the attempt by Germany to revive the political centre ground, not to mention our deep dive into the Balkans, or Russia’s influence on the region - and we will soon publish the second part of our trip report to Germany, a comment on the recent evolution of Italy’s political crisis and our latest update on the customs union options for the UK, post-Brexit. In this column, we try to make sense of all these moving parts, and find the fil rouge connecting all these dots.

Since Europe is still enjoying a generalised economic expansion, with GDP growing above potential in many countries (including the traditional laggards, such as Italy), inflation finally grinding higher and unemployment (slowly) falling, it would be easy to discard all the above-mentioned issues as individual pieces of the messy European jigsaw, relevant domestically, but irrelevant at global level, and from a micro-financial perspective. We wouldn’t agree with this interpretation, for a number of reasons.

First, it is true that economic expansion eases most socio-political tensions, but if they remain in place when the next recession hits (sooner or later, it will happen), they could deflagrate in a less controllable fashion, also from an economic standpoint. Second, if European countries haven’t found a modus operandi in a more integrated union, when the next crisis hits, the asymmetric shocks that would hit the continent could stall any form of further integration process and potentially send it into reverse. Third, Europe has been the epicentre of two world wars in the 20th century, and that was the origin of the European integration process. If that fails, Europe could become again the epicentre of global geopolitical tensions.

So, the question is: how likely is that Europe will experience another severe crisis sooner rather than later? At this juncture we would say: quite likely, with the June 28-29 EU Council meeting being the first step in that direction. In fact, unless a compromise (or a fudge) is found on the Irish border issues, the possibility of a disorderly Brexit with no deal and no transition in 2019 will increase significantly; on the European banking union very little progress will be made, meaning that any form of risk mutualisation will be pushed into the distant future; and now, the euro-redenomination risk will come back on the table, after Italy has adopted another technocratic government which populist parties will use as their target to gain even more votes at the next general election, in September/October 2018 or February/March 2019 at the latest. 

Additionally, Spain is facing its own political crisis, which could also lead to snap elections, and Greece will have to deal with a complex exit from the Troika program. All this, while Germany’s willingness and ability to do “whatever it takes” to save Europe (or at least the Eurozone) has severely diminished. The risk is that summer 2018 will be very hot, not just for climatic reasons.

by Brunello Rosa

21 May 2018 

On Saturday 19 May, US and China issued a joint statement saying that “there was a consensus on taking effective measures to substantially reduce the United States’ trade deficit in goods with China” and that “to meet the growing consumption needs of the Chinese people and the need for high-quality economic development, China will significantly increase purchases of United States goods and services.” The statement remains extremely vague on the detailed actions that will need to be taken in order to achieve the intended results (for example, there is no mention of the USD 200bn target reduction in deficit – from the current USD 350bn – initially mentioned by the US administration). At the same time, it probably marks the beginning of a truce between the two sides, with a dangerous escalation of tariffs and counter-tariffs being put on hold for the time being. 

This is probably good news, at least on a short-term basis, as the combination of rising US Treasury yields, strengthening USD and economic soft patch is key areas of the world economy (e.g. Eurozone and Japan) was already putting the resilience of the ongoing global expansion into question. A full-fledged trade war between two global economic heavyweights would have made the situation much worse, especially for emerging markets, the most fragile of which are already suffering from this dangerous cocktail (especially when domestic policy mishaps are added to the mix, as in the case of Argentina, as discussed in our recent report). 

However, this short-term truce is unlikely to imply the end of the strategic rivalry between the US and China, which instead has just begun. As discussed in our recent paper on US – China trade tensions, what really matters in this story is not the bilateral trade deficit of the US versus China, or the tit-for-tat tariff skirmishes of the last few weeks, but rather the beginning of a long-term rivalry (in both the economic and geo-strategic realms) between US and China, which – according to the new US National Security Strategy, defining China as a new “strategic competitor” – needs to be contained. If this interpretation is correct, the trade, technology, FDI, investment tensions between the US and China will likely escalate in the next few years regardless of any short-term agreement.  

Even if an agreement to avoid a short-term trade war is eventually reached this year, after further negotiations in coming months, this will not be the end of the serious trade and technology tensions between the two sides that will likely increase and escalate over the next few years. A key battlefield in this technological rivalry between the US and China will be in the Artificial Intelligence area, where the formal goal of China is to become the technological leader by 2030. In this respect, the joint statement provides little (if any) reassurance, given the absence of any serious discussion on intellectual property rights (a major complaint by the US administration), as exemplified by the case of the Chinese telecommunications equipment maker ZTE , which is not mentioned in the statement.  In conclusion, whether or not a tactical agreement to avoid a short-term trade war between US and China is reached this year, the strategic economic and geo-political rivalry between the two sides is likely to intensify in coming years.

READ OUR SCENARIO ANALYSIS ON SYRIA

by Brunello Rosa

16 April 2018 

On April 14th, the United States, the United Kingdom and France launched airstrikes targeting sites associated with Syria’s chemical-weapons capabilities. As we discuss in the scenario analysis that we publish today, in our baseline, this will remain a one-off episode, whose economic impact and repercussions on financial markets are likely to be limited, apart from some short-lived volatility in equity and oil prices, and a possible fall in US Treasury long-term yields. 

If our baseline is correct, this military strike was justified by the need to punish the Syrian regime for the alleged use of chemical weapons in the April 7th attack on the city of Douma, which the government denies. Chemical weapons have been internationally banned since April 1997. Former US President Barack Obama set the use of chemical weapons as a “red line,” and therefore a trigger for intervention in Syria, but subsequently avoided any involvement following the September 2013 Ghouta chemical attack. Therefore, President Trump would be rightly reacting to Syria crossing an internationally sanctioned “red line:” he has taken retaliatory measures after both April 2017 and April 2018 chemical attacks. 

“Tit for Tat” is the game-theoretical strategy of “equivalent retaliation” that seems to be very much in vogue in DC in this period: let’s not forget the lingering trade war between US and China, which the two sides are fighting along the same lines. The problem with that strategy is that it might lead to the stabilisation of the situation with a new (not necessarily better) equilibrium. Or it might, conversely, lead to a further escalation of tensions if the response is not considered proportionate by one of the two contenders, or if other actors enter the scene (in the Syrian crisis, it could be Russia intervening in the conflict). It’s too early to say whether these two (very different types of) wars will further escalate or subside. But there is definitely a more “assertive” stance prevailing in DC at this stage, compared to the past, on a number of dossiers. 

We discussed in previous columns how the changes recently occurred in the team of advisors of the US President and top US officials (moderate pragmatists were replaced by more ideologically driven hawks) could eventually lead to increased tensions on a several fronts. We didn’t need to wait too long to see the effects of those changes. A collateral effect of a state of war in the US is that the President, as commander-in-chief, gains manoeuvring space and alignment of the administration, including the so-called “deep state,” behind him. 

In conclusion, it is perfectly legitimate and justified to react when "red lines" are crossed. The question here is whether the series of events of the last few weeks are starting to represent "red flags" for how the situation can evolve in the months and years to come. 

by Brunello Rosa

9 April 2018

Last Friday, equity markets sold off sharply on the back of the lower-than-expected NFP figures (103K jobs added in March, versus 193K expected) and renewed trade war fears. The below-consensus NFP figure need to be considered on a multi-month basis and could have been expected, to some extent, after the sharp 313K increase recorded last month (more than 100K above consensus). So the March figures don’t need to be considered per se as a sign of a weakening labour market, especially after Fed Chairman Jay Powell said (earlier last week), that subdued wage growth signals that the US labour market “is not excessively tight.” A fortiori, this month’s NFP figures cannot be considered indicative of an imminent slowdown of the US economy, which might, in fact, be in acceleration phase, partly as a result of the fiscal stimulus imparted by the tax cuts and the fiscal spending deliberated by the US administration in the last few months. 

More worrying is the impact that fears of a potentially escalating trade war between US and China is having on investor sentiment and equity price dynamics. After the initial move by the US (which threatened to impose 25% duties on 1333 products, worth around $50bn, related to China’s alleged theft of US intellectual property), and the initially modest retaliatory move by China, threatening to impose tariffs on (well-targeted) imports worth USD 3bn, the US has threatened to impose additional USD 100bn in tariffs on imports from China, when China threatened to impose tariffs on 106 products (including soybeans, cars and chemicals) worth USD 50bn. This tit-for-tat game (which, as history teaches, ends up destroying value for all sides, with no eventual winner) is unnerving market participants, who fear a full-blown trade war that could eventually spark a global recession. 

Clearly, a trade war is not in the interest of either contender: the US cannot seriously threaten a major holder of its public and agency debt, without endangering its financial stability, and the value of the US dollar; China cannot seriously threaten a major buyer of its global exports, and the currency in which most of its foreign reserves are denominated. So, game theory would suggest that a solution can be found after the US administration would have symbolically proven that the US will not observe the rise of China as a strategic rival without reacting, and the promise by China to open up its markets over time; and after China would have proven to be the rising hegemonic power, able to call the US as the violator of WTO rules. But it will take time for that equilibrium to be reached. In the meanwhile, markets will remain jittery, and investor sentiment under the cosh. 

In our analysis in February, we discussed how hard it will be for equity markets to return to the January peaks, and recent developments seem to confirm that this will be the case. In such an environment, our updated pro-forma strategic asset allocation continues to favour a moderate risk taking within a defensive positioning, with slightly greater exposure to sovereign bonds and lower to commodities. 

by Brunello Rosa

3 April 2018

Year 2018 witnessed one of the best starts in the last couple of decades, with the stock market rallying on the back of the fiscal reform (aka “tax cuts”) approved by the US administration at the end of last year, which was followed in short order by the approval of additional fiscal spending, partly devoted to infrastructure plans. This fiscal expansion by the largest economy in the world at the time the global economy is already experiencing a synchronised expansion, on the one hand further boosted investor confidence, on the other hand fuelled inflation fears that crystallised at the beginning of February, when US average hourly earnings for January came out at 2.9% y/y. Those fears, and the related fears of a faster tightening by the Fed, conjured to create the correction in the equity market experienced in February. At that point, we were of the view that a full-fledged bear market would be unlikely, but also that stock indices would be unlikely to return to January peaks, as four factors would continue weighing on valuations: (1) inflation scares (as opposed to outturns); (2) rising protectionism; (3) volatility and (4) (geo)political issues. 

At the end of the quarter, most equity markets (especially in DM) closed Q1 in the red, with the S&P500 experiencing the first quarterly loss since 2015, as those factors are all still at play. Inflation fears remain, in our opinion, over-hyped, as the structural factors that keep global inflation in check (technological advancement, globalisation, flatter Phillips curve) are still very much at work, but investors remain concerned that those central banks normalising their policy stance (and chiefly, the Fed), would react to rising inflation by raising rates faster and higher. The imposition of tariffs on steel, aluminium and IP by the US, which is generating some retaliatory action by the affected countries, are weighing on investor sentiment, although the policy uncertainty related to the actual implementation of those protectionist measures is creating volatility in the market, as testified by last week’s equity rally, prompted by reduced fears of an imminent trade war. Finally, geopolitical events remain on the back of investor’s minds, as they have not been able so far to dent their sentiment, but have the potential of causing massive cumulative effects if they materialise. Between trade wars and geopolitical events sits Brexit, which could prove very costly for the UK if the country will end up leaving the EU with no deal, thus falling into WTO rules (or “below”) for international trading, at the time of rising protectionism.

All these issues will remain in place also in Q2, when a new set of challenges will come to the fore, and chiefly: will the Fed continue its policy normalisation at the currently forecast pace of three hikes in 2018, or will increase its pace? Will the ECB signal further tapering of QE in June? Will Italy be able to form a government that will remain compliant with EU fiscal discipline, or will it start adopting a much more confrontational stance with the EU? The good news is that an expanding global economy allows reforms to be made and provides resilience in the face of materialising risks. On the other hand, it’s the accumulation of risks that eventually dents investor confidence and prompt a re-thinking of perspective returns on investment. 

Given this background, our updated strategic asset allocation continues to favour a moderate risk taking (i.e. skew towards equities) within a defensive positioning, with a slight increase in exposure to sovereign bonds and lower exposure to commodities.

by Brunello Rosa

26 March 2018  

Last week, the Fed implemented the widely expected 25-bps increase in the Fed funds target range: the FOMC delivered a “relatively” hawkish hike, accompanied by an upward revision to the growth, inflation, employment and policy rate outlook. The main reason why the overall message was only “relatively” hawkish (in line with our preview), is that the new Fed Chair, Jeremy Powell, performed a very convincing press conference (his first), in which he abundantly caveated the FOMC forecasts, arguing that the future is so uncertain that effectively anything can happen, to the point that there is no urgency to start indicating already in March that four Fed funds hikes in 2018 are necessary. 

Jay Powell was appointed by President Trump to provide continuity with his predecessor, the dovish Janet Yellen, and make sure that the Fed would not undo all the efforts the US administration is making to further boost economic activity (with the risk of “over-heating”) with a faster monetary policy tightening. And, as a corollary, make sure that the dollar does not strengthen too much in spite of the rate normalisation, but actually remains relatively weak (even in presence of tariffs on steel, aluminum and now intellectual property rights). With a gradual monetary policy tightening, a Fed’s balance sheet reduction effectively on auto-pilot, and by keeping a low profile, Jay Powell is delivering on the job he was given and can be considered with reason a good choice by Trump.

Less reassuring, though, are other changes that have been taking place within the US administration in recent weeks. The departure, for various reasons, of respected figures such as Gary Cohn as Director of the National Economic Council, Rex Tillerson as Secretary of State, H.R. McMaster as National Security Advisor give the impression that the team of experts that was advising the President on key strategic matters (of both economic and geopolitical nature) and to some extent “moderating” some of his more extreme intentions and policy plans is now being dissolved, in favour of more hawkish figures (chiefly the neo-Con John Bolton as new National Security Advisor). One can reasonably wonder when the other two former generals that currently are in key government positions (James Mattis as Defense Secretary and John F. Kelly as Chief of Staff) will also depart, leaving the room to less moderate substitutes. 

As the example of Jay Powell shows, the choice of people in charge determine the credibility, policy direction and the ability to deliver of the institutions. The choice of the US administration to start imposing tariffs on key inputs for the globalised economic system, exposing the US to the risk of retaliations and a potential trade war, suggests that the new course of action in DC (likely shaped by new advisors) is less favourable for the global economy and even financial markets (as shown by the sell-off in equity markets last week, the worst in more than the last two years. In mid-February, we warned this could be the case). It is not a mystery that geostrategic and macrofinancial issues are now intimately interrelated: the geopolitical tensions between US and North Korea (ahead of a foreseen meeting between Trump and Kim) and the trade war with China, still one of the largest holders of US Treasuries, are all parts of the same complex jigsaw. Equally, the relationship with Russia has both economic and geopolitical ramifications.  

As discussed in our previous columns, the rise of authoritarian leaders at the time protectionism and trade wars are re-emerging does not bode well for the global economy and financial markets (even if those risks might crystallise only in the medium term). In this dangerous environment, it is legitimate to question whether or not the US want to remain the global champion of liberal democracy and free markets, as they have been for the last several decades.  

 by Brunello Rosa

19 February 2018  

Last week staged a rebound in equity markets after the sell-off of the previous days: on a weekly basis, the S&P500 rose by 4.2%, and VIX declined by 30% to 19.5. So, for the time being, the market has moved along the lines we highlighted at the beginning of the sell-off (see our weekly column of 5 February 2018), when we thought this would not represent the beginning of a bear market, and we suggested investors should get used to an environment of higher volatility in equity and bonds and higher sovereign yields due to the increase in the inflation risk premium included in the term premium embedded in long-term rates. 

At the same time, the market remains particularly susceptible to inflation surprises (which can easily translate in “inflation scares”), as the sell-off in equities showed last week at the time of the publication of US inflation data, when January CPI came in unchanged from December at 2.1% y/y, against expectations of a drop to 1.9%. In particular, the fiscal and investment plans of the US administration, at this stage of the business cycle, risk being mostly inflationary, forcing the Fed to tighten more and faster. So, we expect inflation and higher yields and volatility to continue weighing on the US (and other) equity prices going forward, making it harder for equity indices to rise much beyond previous highs. 

Of course, central banks are vigilant on the inflation phenomenon, with the Federal Reserves under Jay Powell, with a slightly more hawkish FOMC composition, likely to increase the Fed funds target range in March. But not all central banks are joining the Fed, Bank of Canada and Bank of England in their policy tightening cycles. The ECB and the BoJ have re-affirmed that they intend to continue providing monetary stimulus until inflation shows signs of sustainable upward trend towards the 2% target. The Swedish Riksbank has recently revised downward its inflation forecasts, likely implying a postponement of the expected time of the lift-off. 

Low for longer yields in Europe and Japan will continue to constitute an anchor for US Treasury yields, with the 10y yield unlikely to rise much beyond 3%. The main upside risk is represented by an increase in real yields due to a rise in the US budget deficit and debt for the next few years (with the GOP abandoning their traditional stance of fiscal prudence). More in general, a continued accommodative monetary stance should help the global economy to remain in the ongoing synchronized expansion, unless some unexpected shock, including of geopolitical nature, brings this to a sudden end.     

by Brunello Rosa

12 February 2018

As the market tries to settle after a week of elevated volatility, re-rating of risk appetite and re-pricing of securities across the board, we would like to highlight the remarkable resilience of emerging markets in this turbulent context. If we look at MSCI indexes, emerging equity markets had outperformed DMs in the January 2018 rally (+7.5% versus 5.8%) and slightly underperformed DMs in the sell-off (-10.2% vs -8.8%, mirroring the re-widening of credit spreads), but their performance since the beginning of the year has been in line with the global index (-3.5%).

At the time of the 2013 taper tantrum, the sell-off at the long end of the US yield curve (when the 10y US Treasury yield reached 3%) sent shockwaves through the system that impacted mostly EMs, in particular the so-called Fragile Five economies (Turkey, Brazil, India, South Africa, Indonesia) which were most exposed because of their large current account deficits and external debt. On the other hand, in our recent analysis on EM currencies, we had already noted how emerging economies (including the Fragile Five) had repaired some of their domestic and external balance sheets, thus proving more resilient to the Fed’s interest rate normalisation and potential dollar appreciation.

Our recent travel notes from Turkey (one of the most fragile economies from an external perspective, with a still-large current account deficit) highlighted how the country’s cyclical economic resilience (flirting with over-heating, at times) was able to compensate the historical structural economic deficiencies, even within a complicated domestic political and international geopolitical environment. Our analysis on China in January discussed how the managed economic transition from an investment-driven to a consumption-led economy was likely to result in a gradual, if bumpy, slowdown, rather than a crash, thanks to a political system that had just renewed its confidence in the single-party system, and its supreme leader, President Xi, and how this would allow the Asian giant to whether not just a passing storm, but even a systemic crisis. In Brazil, in the middle of the market sell-off, the central bank even found room to cut its policy rate by 25bps to 6.75% (a historic low), taking advantage of falling inflation, in sharp contrast with the defensive hikes that some EMs had been forced to undertake in the past, to defend their currencies from a rapid depreciation (and a potential subsequent spike in inflation).

More in general, during this sell-off episode emerging markets have found resilience in a number of concurring factors, including: first, synchronised global growth will continue to exert a positive influence on EMs, most of which still depend on export to grow; second, the stabilisation of commodity prices in 2016-17 has also helped stabilise the EM business cycle; third, the build-up of foreign reserves and the shrinking of current account deficits have made most EMs less sensitive to sudden market reversals; fourth, the fact that the dollar index only appreciated 2.2% during the sell-off meant that EMs did not suffer massive currency outflows. 

Going forward, assuming the US inflation scare does not intensify, investors cite still positive yield differential between DM (in particular US) rates and EM rates and the relative cheapness of EM versus DM equity on a P/E basis to justify continued search for opportunity in the EM fixed income and equity spaces. A worsening of the sell-off would most likely induce a re-thinking of this position, even if the impact on EM would likely be smaller than in 2013, considering better economic fundamentals. 

Clearly other structural risks exist that suggest cautiousness in EM exposure, such as a political cycle with elections in Mexico, Brazil, Russia and soon South Africa, the build-up of a large amount of corporate debt (often dollar-denominated), the potential fallout of protectionist measures from the US administration (e.g. stand-off of Nafta negotiations) and geopolitical risks in various parts of the world. 

by Brunello Rosa

5 February 2018

Last week staged the contemporaneous rise in long-term yields in US and other markets and a correction in equity markets, with the S&P500 losing 3.9% w-o-w, the worst weekly performance in two years. This market reaction was triggered by central bank communication and data releases. On Wednesday, the FOMC statement highlighted that “inflation on a 12-month basis is expected to move up this year” and stabilise around the FOMC’s 2% objective over the medium term, opening the doors to a further 25-bps rate increase in March, in line with our preview. On Friday, the January 2018 employment report showed a solid 200k increase in non-farm payrolls, beating expectations for a 180k rise, versus an upwardly revised figure in December of 160k, with the unemployment rate remaining at the record low of 4.1%. More importantly, labour market data showed signs of vitality in labour compensation, with wages growing 2.9% y/y, increasing concerns about rising inflation. 

Better economic data and central bank communication, suggesting reduced policy support and further liquidity withdrawal, triggered a bond sell-off (and potentially a revision of investor’s interest rates expectations). During the week, 10y UST yields rose from 2.66% to 2.84%—a four-year high. In the EU, the German 10y bund yield rose from 0.63% to 0.76%. This rise in yields has been driven by an increase in the nominal (rather than the real) component of long-term rates, and in particular by the normalisation of the inflation risk premium, rather than an increase in inflation expectations. In spite of higher US Treasury yields and expectation of potentially higher policy rates, the USD kept depreciating, with EUR/USD rising above 1.25 for the first time since December 2014, to close the week at EUR/USD 1.248, a 0.9% w-o-w depreciation of the USD vs the EUR. 

The event of the past week confirmed what we suggested in our Viewsletter of 15 January 2018(“A Bumper Start of the Year Still Requires Some Cautiousness”) and are in line with our 2018 Global Economic Outlook (“Smooth Sailing for Now, With Headwind Risks Rising”) and 2018 Strategic Asset Allocation (“Moderate Risk-Taking Within A Defensive Positioning”). With equities having staged the best start of the year for the last 20 years (with S&P500 having returned 5% year-to-date), it would be premature to consider this episode as the beginning of a protracted correction, in particular considering that the rise in yields is underpinned by improving economic fundamentals. At the same time, investors should be wary of short-term market reversals, and therefore of increased volatility, in this environment. 

As we discussed in our Outlook, one of the greatest macroeconomic risks for 2018, underpinning what we labelled as a “malign upside scenario”, is an unexpected rise in inflation, which forces global central banks, and primarily the Fed, to increase rates faster than initially anticipated (or signal a faster pace of policy normalisation), thus worsening the initial market reversal deriving by rising yields. At the same time, investors should hold their nerves, as global inflation remains largely under control, as we discussed in our Viewsletter of 8 January(“Neither Permanent, Nor Temporary, But “Persistently” Low Inflation”). In many large areas of the global economy (including Europe and Japan), there’s still plenty of work to do to bring inflation on a sustainable path in line with central bank targets, and the powerful forces of globalisation and technological innovation, with their impact on income distribution and inequality, are still at play. 

As a result, investors should not be scared of moderate rises in wage growth and inflation, and therefore in yields, in line with an improved economic outlook. Still-low German and Japanese long-term yields will continue to constitute an anchor also for US Treasury rates.

by Brunello Rosa

29 January 2018

As discussed in our recent review of ECB policy meeting of January 25th and preview of the FOMC meeting on January 31st, during the past week we have observed an abrupt resurgence of what somebody could emphatically call “currency war.” The renewed dispute around the desirable level of a country’s currency versus the others was kicked off by the comments from the Treasury Secretary Steve Mnuchin, who said that a weak dollar was good for the U.S. trade. After ECB President Draghi expressed disappointment for a comment that - in his opinion - violated the terms of reference on currency management agreed at international level, in the evening of January 25th, President Trump reassured market participants by saying that he was in favour of a strong dollar, soon followed again by Mnuchin who, on Friday 26th, said that a stronger dollar would be in the best interest of the US. It is not a surprise if - in all this - EUR/USD proved extremely volatile: the currency pair begun the week at 1.22, jumped to 1.25 during Draghi’s press conference on Thursday 25th, and closed on Friday at just above 1.24.

What are the ingredients of what we could call, more pragmatically, “lingering,” or “low-intensity” currency war?  In the immediate aftermath of the financial crisis (in London), G20 countries renewed their pledge not to indulge in competitive devaluations, but soon after engaged in a “currency war” by proxy, in terms of competitive increases of the central banks’ balance sheets, another way of re-flating the economy, debasing the currency and ultimately induce a currency depreciation against all other currencies. All major DM central banks engaged in such a borderline acceptable practice, behind the fig leaf that ultra-expansionary monetary policies were motivated by domestic reasons, with the effect on the currency only being an unwanted (but welcome!) “collateral damage”. 

In this phase, central banks’ behaviour is relevant from a different perspective: considering the diverging monetary path by the Fed (engaged in rates normalisation and balance sheet reduction) and the ECB (still adopting a negative policy rate and balance sheet expansion) one would expect EUR/USD to depreciate, rather than appreciate. However, the policy path expected by the market given the stage in the economic cycle, compared to what the central bank actually does, could make the difference. The Fed continues delivering “dovish hikes,” while the ECB is engaged in a slow exit from its extraordinary accommodation. 

Besides this and other cyclical factors (e.g. inflows into equity markets) there are two structural factors behind the lingering currency war: one is the trade policy, the other the tax policy. On trade, the Eurozone continues to exhibit a current account surplus (a result of the German-mandated fiscal austerity imposed to the continent) that structurally strengthen the currency, while the US has still a current account deficit which favours a weaker currency, in spite of the threatened “protectionist” measures that would make the USD, at the margin and ceteris paribus, stronger. On fiscal policy, the recent US tax cuts is likely to create a fiscal and current account deficit that would, over the medium term, favour the weakening of the USD in spite of all declarations by US officials. The German-led Eurozone will find it hard to respond to this round of US fiscal easing in spite of the re-emerging grand coalition. 

We will likely observe other episodes of this new lingering currency war in coming months. Being a fiscal and political union, the US is much better equipped than the Eurozone (a sub-optimal currency area) to fight this war. Other jurisdictions, such as the UK (busy with Brexit) and Japan (still battling with low inflation) will try to respond with their more limited weapons to this new challenge.

By Brunello Rosa

27 December 2017

Global Economic Outlook 

We are in the last few days of 2017, and so it is natural to have a look at the year about to begin and how we see it. As we have recently discussed in our 2018 Global Economic Outlook, we believe that the growth momentum that has characterised 2017 (as a moderate, global expansion), will likely continue in 2018. In fact, the global economy and financial markets currently appear in a sort of Goldilocks period of growth and inflation being not too cold and not too hot. Since the summer of 2016, the global economy has been in an expansion stage, positive growth that is accelerating in most key countries and regions. In most developed markets and emerging economies, there is an expansion as opposed to the slowdown – positive but slowing growth - that was observed in the two risk-off episodes of Q3 2015 and Q1 2016. 

One might wonder whether such a prolonged period of expansion would eventually end, being already quite mature. But economic expansions don’t die out of old age or natural death, as recessions are caused either by domestic or external shocks. In our global economic outlook, we consider a number of headwind risks: China hard landing, geopolitical risks, US/Trump, surge in long-term yields, a shock widening credit spreads, Eurozone risks resurfacing, not enough capex in energy-consuming economies. In our view, none of them is likely enough to trigger a sharp risk-off episode, although even a milder combination of some of them may trigger volatility and market correction of risky assets from elevated levels. In our outlook, we also discuss two alternative scenarios (upside and downside) compared to the baseline of a continued moderated expansion.

Implications for financial markets and asset allocation 

When the economy is in global expansion, inflation remains well-behaved, central banks are either normalising slowly or providing continued accommodation, fiscal policy is neutral at worst, regulation is set to become looser, naturally risk is “on” and risky asset prices are on their way up. At the same time, valuations are stretched, credit spreads low and private and public debt piling up. So, the risk of a “Minsky moment” is increasing significantly and may materialize in 2019-2020 if the current asset and credit cycle turns into a full-blown bubble. Also, we consider a big macro shock a necessary condition for a significant market correction (a 10% US and global equities correction), and this is a likely risk scenario, rather than our baseline for 2018. 

In our 2018 Strategic Asset Allocation paper, we discuss the implications for asset allocation of such an environment, which remains challenging, as expected returns are likely to remain lower than during the pre-crisis period. In our view, in the context described above, a moderate risk-taking within a defensive positioning is justified. Achieving the goal of wealth preservation would require adopting conservative investment strategies, with a greater exposure to alternatives to provide some incremental return.

By Brunello Rosa

(Original Version 18 December, Updated 

on 22 December 2017)  

On Thursday 21 December, 4.3 million Catalans went to the polls (for a record 81.9% turnout), and elect their regional Parliament, which was dissolved after Madrid took over the rule of the region, following the application of article 155 of the Constitution on 28 October. 

As we discussed in our recent paper, the Spanish government chose a day in the middle of the week to hold the election in order to increase the participation of the “silent” majority of the Catalans, which was supposedly against independence; at the same time hoping for a reduced mobilisation of the pro-independence parties and their affiliates and supporters, already badly hit by the incarceration of the leaders of the pro-independence movement. 

The result was quite different from what the Government was hoping for. The pro-independence front, constituted by JuntsxCat (led by Carles Puigdemont from the “exile” in Brussels), ERC (the pro-independence, left-wing party led by Oriol Junqueras, now in prison) and CUP obtained 70 seats out of 135. The first party was Ciudadanos (Cs) led by Ines Arrimadas, which won 37 seats, but the unionist front with PSC-PSOE and PP only got 67 seats in the regional parliament. It won’t be easy for the pro-independence front to converge on a common President of the Generalitat (the first round needs to take place by February 10th), although JuntsxCat and ERC seem willing to cooperate to form a government running an independentist platform, although less radical than the one that led to the unilateral declaration of independence. 

Theoretically speaking, CatComu’-Podem (the local declination of Podemos), which gathered 7.5% of votes and 8 seats, could be the kingmaker. As we have discussed in our publications, if it joined forces with ERC and the pro-independence movement, it might push for the adoption of a Scotland-type independence referendum, i.e. a legitimate consultation approved by Madrid (after a constitutional reform or with a constitutional law). However, so far Podemos has decided not to take sides, considering that Ada Colau, the mayor of Barcelona, remains on the fence. In coming weeks, we will see whether they decide to take a more active role. 

In any case, as we warned already in our initial working paper, the issue of Catalan independence will not be settled for some time, and its economic repercussions will continue to be felt across the board. After the elections, the equity prices of the regional banks lost 3%, impacting the overall national index, which has been the underperformer of Europe since May. The impact on the Catalan economy of the unilateral proclamation of independence has been indubitably negative, with thousands of companies forced to relocate their registered office (if not their trading offices) outside Catalonia, to protect themselves against a potential escalation of the tensions. But the result of the elections show that somehow the independence “dreamland” is still considered attractive by a vast proportion of the Catalan electorate.

Two weeks after the EU Council gave green light to the second phase of “Brexit” negotiations and Corsica saw the convincing victory of the pro-autonomy front, the issue of the Catalan independence returned to the fore, to show once again that the institutional setting of regions within the EU is a pan-European issue. We have argued that the creation of sub-national or trans-national regions as the center of the political decision-making process is one of the key areas in which the EU needs to make progress, if it wants to survive in the long run. This week’s election has been a clear reminder of this urgent need. 

(Renata Bossini contributed to this analysis) 

By Brunello Rosa

11 December 2017

After six months of negotiations, a preliminary deal has been reached between the UK and the EU to “unlock” the talks on the “second phase” of the Brexit negotiations, when a new “trading arrangement” will have to be established between the two sides.

While welcoming these developments, which are also in line with our narrative and scenario analysis, at this stage we consider more relevant to emphasise that this is just the beginning of a very long process, which is likely to be bumpy until the very end. The UK will likely have to compromise on a number of issues, and in some cases capitulate. 

According to the text agreed in Brussels on 8 December, if “no deal” is reached between the UK and the EU, the entire UK will have to guarantee “full alignment” with the EU rules of the single market and the customs union, to prevent a hard border from re-emerging between Northern Ireland and EIRE. This would look very similar to a “Norway-style” solution, which is considered unacceptable by the vast majority of UK political leaders. On the other hand, if the eventual outcome is a Canada-Style FTA, this is very similar to “hard” Brexit, and with very little protection for the financial services industry; again, a sub-optimal outcome to say the least. 

But other outcomes are also possible, depending on the political economy of events. To elucidate this point, in our latest Working Paper, we take as an example the negotiations occurred between Greece and the EU in 2015. Apart from the obvious differences, there are several lessons that can be drawn from that experience, and in particular that: 1) a series of elections and referendums might be required to get to the eventual political equilibrium; 2) the political party that starts the process might not be the one that manages – and finishes – it; 3) all sides of the negotiations should be prepared for unexpected U-turns; 4) Negotiations tend to finish at the 11th hour, and beyond; 5) The eventual outcome might be very different from the initially expected results.  

Comparing the Greek sequence of events in 2009-2015 with the Brexit timeline (starting from 2015) reveals that the UK is only at the very beginning of a long process, which might evolve in many different directions. As we discussed in our previous reports, given the current information set, a Canada-style FTA agreement seems the most likely scenario. But the information set will evolve over time, and with it the possible potential outcomes. 

By Brunello Rosa

4 December 2017

The current consensus view is that Germany’s political deadlock could be solved only by the SPD entering again a “grand coalition” with the CDU/CSU. This would represent good news for both Germany and Europe because: domestically, a “grand coalition” would likely last longer than a minority government or a Jamaica coalition, and an SPD-led finance ministry would partly soften the fiscal discipline imposed by former Finance Minister W. Schäuble; and internationally, the SPD would push for more European integration than a Jamaica coalition would have done, and would make German commitments more credible. 

It is true that the more pro-European set of German policies deriving from this baseline scenario, coupled with French President Macron’s push for more domestic reform as well as European integration and risk sharing should be able to at least counterbalance the centrifugal forces coming from Britain, as well as Southern and Eastern Europe, allowing the European integration process to muddle through for a few more years. At the same time, in our view, there are two downside risks that cannot be underestimated.

First, Germany traditionally tends to have a conservative fiscal stance regardless of the ruling coalition. So, even if a grand coalition is formed, the SPD might not be in the position of significantly moving this needle of German policymaking, in spite of somewhat increased infrastructure investment and higher spending on social programs. Secondly, if the grand coalition fails there is a risk of making euro-skeptic AfD and FDP stronger and that would be bad for Germany and for Europe down the line. In fact, if the SPD enters timidly the grand coalition (as it was the case in 2005-2009, and in 2013-2017), at the end of this experience its political capital could be completely exhausted, with the serious risk of becoming an irrelevant party like other socialist parties in Europe (e.g. PS in France, PSOE in Spain and PASOK in Greece), with the Greens and the Left sharing the spoils of the left-wing electorate. At the same time, a Merkel-less CDU could also be in dire straits, unable to attract more than 20-25% of votes, leaving a large proportion of the right-wing electorate to the FDP and AfD (which already now have, combined, almost 25% of the votes). 

This means that, at the end of this experience (in 3-4 years), Germany runs the risk of finding itself with an even more fragmented political spectrum, unable to form a governing coalition, and express a government strong enough to complete the European integration process, when centrifugal forces could be even stronger. We have already argued that the 2017-2022 years are the most critical for Europe, when the integration process must be put on serious track for completion. Failure to do so would mean that 4-5 years from now, the ongoing dis-integration process would become unstoppable, and would likely lead to a re-configuration of Europe in clusters of countries with strategically diverging objectives.