Weekly Columns (Archive)

The Failure Of Germany’s Grand Coalition

by Brunello Rosa

5 November 2018

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

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

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

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

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

Bolsonaro’s Presidency: A Likely Mix of Trump, Peron, and Pinochet

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.”

Markets Stabilise After Large Sell-Off, But Risks Remain

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.   

IMF Downgrades World Economic Outlook in 2019, Citing “Challenges To Steady Growth”

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%.   

Will The World’s Next Strongman Come From Brazil?

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. 

The Final Quarter of 2018 Begins, With Plenty of Risks (and Some Opportunities)

by Brunello Rosa

1 October 2018

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

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

In Q4, growth in global economic activity will continue but will be even more asynchronous, as a deceleration continues in Europe, Japan and most emerging markets. The Fed will continue to tighten its policy stance, no longer “accommodative”, while the ECB will end its QE program in December.  The BOJ might also continue to tweak its policy to continue exiting its extraordinarily accommodative stance of the last few years.

As a result, during this final quarter of 2018 (and continuing in 2019), the risk of a correction in European and EM equity prices will increase due to liquidity withdrawal and political tensions. Analysts’ expectations of stock markets for the next 12 months - expectations of a more than 10% rise in DMs, and around a 20% rise in EMs - seem overoptimistic. 

US 10-year bond yield will likely remain above 3% in Q4  because of declining liquidity and rising issuance, but steady demand is likely to keep it capped. In EMs, bond yields are also likely to increase. We expect oil prices to remain above USD 70/b, supported by strong demand and supply constraints in OPEC and the US. Given diminishing USD liquidity and rising risks in Europe and EMs, investors’ portfolios are likely to gradually de-risk. A number of “special situations” will attract investor attention, meanwhile. In DMs, US mid-term elections in November, Brexit negotiations, Italy’s budget fist-fight with the EU will all attract attention; in EMs, elections in Brazil at the end of this week (on which we will publish a forthcoming report) will do so, as will US-China trade wars and the ongoing situation in Argentina and in Turkey.


Further ahead, in 2019, growth is likely to soften at the global level, with both DM (including the US) and EM economies decelerating. At this stage, we believe that a generalised EM crisis is unlikely because global liquidity remains elevated (even if it is contracting) and fundamentals remain solid in most emerging economies. In 2020, however, the risk of a global recession is higher than most analysts currently foresee.  On a multi-year horizon, then, investors’ portfolios are likely to be re-adjusted to ensure capital preservation.

In Q3 Final Week, Investors will Focus on the Fed, Brexit and Italy

by Brunello Rosa

24 September 2018

This is the final week of the 2018 third quarter, a quarter which saw some diverging trends take place within the global economy. On the one hand, the US has continued to grow at a robust pace, adding 200K jobs per month and reaching an unemployment rate that is below 4%. Inflation in the US is now consistently above the Fed’s 2% target. As a result, equity markets have registered new record highs, the yield curve is almost inverted, and the US dollar is stronger than it was at the beginning of the year (in trade-weighted terms). 

Conversely, the stock market indices of many emerging economies, including China, have entered bear-market territory, and their currencies have depreciated significantly against the USD. This divergence between the US and emerging economies has been partially a consequence of the intensification of trade skirmishes between the US and China (and between the US and the rest of the world, in spite of its recent deals with Mexico and the EU), and of their underlying technological war

As we discuss in our preview, the  Fed will increase its policy target range by 25bps this week, but it will also have to address the following issues: the inversion of the yield curve and its implications for the real economy; USD strength; effects on EMs; and US policy normalisation occurring during a period in which the world economy is weakening. With the 2021 “SEP dots” being revealed for the first time, will the Fed start taking into account the mounting concerns about a 2020 recession? Or will it ignore these concerns, as it did when it carried out is most recent rate increase in June? After all, during this quarter the 10th anniversary of Lehman’s collapse took place, and there is a risk that a new financial crisis might already be brewing.

In the final week of the third quarter, two long-standing issues will come to the fore: Brexit and Italy’s budget. In the wake of the EU having rebuffed Theresa May’s Chequers proposal, we are entering the final stage of the Brexit negotiations. These should lead to an agreement on the Withdrawal Treaty being reached by the end of October, in time for UK and EU approval before the date of Brexit on March 29th, 2019. This week, the Labour Party conference will help to clarify the party’s position on the Withdrawal bill; Jeremy Corbyn recently said that Labour MPs are ready to vote against the bill if it fails the Six Tests (as it is certain to do). Labour seems ready to exploit May’s failure in the negotiations in order to return to power after eight years in opposition. As discussed in our column on September 3rd, next week’s Tory party conference will be the last chance for the Conservatives to find a common position on Brexit negotiations. 

Also this week, as we discussed in our recent trip report, the Italian government will have to present its update of the Document of Economy and Finance, i.e. the draft of the budget for the 2019-21 period. There is an ongoing tug of war between the prudent finance minister Giovanni Tria and his technocrats (who recently came under heavy attack from one of Prime Minister Conte’s spokesmen), and the political leaders of the Five Star and Lega, who are pushing for the budget to include at least a preliminary implementation of the massive fiscal promises made during the electoral campaign, such as the introduction of a minimum income, the reduction of pensionable ages, and the introduction of a flat tax regime. The market expects the finance minister’s prudent approach to eventually prevail; it expects the budget to indicate a fiscal deficit for 2019 that will not be too far from the 1.6% level that would allow Italy to remain committed to its fiscal consolidation plan. Should this fail to occur, a new period of market volatility, accompanied by rating agencies’ downgrades of Italy’s creditworthiness, would be likely to ensue.   

10 Years After Lehman’s Collapse, Economies Are Sowing the Seeds of the Next Crisis

Picture by Mark Lennihan/Associated Press 

by Brunello Rosa

17 September 2018

September 15th, 2008: financial services firm Lehman Brothers files for Chapter 11 bankruptcy protection. This is the largest default in U.S. history, and marks the beginning of the Global Financial Crisis (GFC), the most severe episode of financial instability and economic contraction since the Great Depressions of the 1930s. From late 2006/early 2007, when the first elements of the crisis start to emerge, until September 2008, the crisis is mostly confined to the financial sector, having little impact on real economic activity. After Lehman’s collapse, however, the crisis becomes truly global. A number of economies enter a severe recession in 2009; they will emerge from this recession only a number of years later, profoundly transformed. 

September 15th, 2018: ten years after Lehman’s collapse, it is evident how the consequences of the 2008 GFC have gone far beyond the financial industry and the real economy. New political movements have emerged, and a world-wide retreat of globalization has begun, in a process that is still ongoing. The eventual outcome of this process has not yet become clear. In a Special Paper published by the Systemic Risk Centre of the London School of Economics(derived from a video interview by Angela Antetomaso with Nouriel Roubini and myself, which is available on a page dedicated to the 10th anniversary of the GFC of our website), we analyse what went wrong in 2008, and what lessons have been learnt to prevent another crisis of similar proportions from emerging again. We discuss the perverse relationships that often exist between academics, regulators, market participants and politicians, and why the institutions that were supposed to look after the economic and financial stability of countries failed to prevent the excesses of finance from occurring. 

We analyse the effectiveness of the instruments of fiscal and monetary policy adopted to counter the effects of the crisis, and we highlight the insufficient use of fiscal policies, which at least in Europe would have helped alleviate the effects of the economic downturn. The link between financial crisis, economic contraction and the rise of populist parties, which led to Brexit and the election of Donald Trump, can clearly be seen. In this context, rising geopolitical tensions occurring within a deteriorating macro environment, as well as increased financial fragility, might trigger a new crisis that could be worse than the GFC. 

In recent articles published by the Financial Times and Project Syndicate, we explain how economies today have already sowed the seeds of the next global recession and financial crisis. We expect such a crisis to materialise by 2020, for the following ten reasons: 1) the fiscal drag on the US economy in 2020, as Trump’s fiscal stimulus expires; 2) the continuation of monetary policy tightening by the Fed and the beginning of interest rate normalisation by the ECB and BOJ, as inflation rates return toward central banks’ target levels; 3) the effects of trade wars and protectionism; 4) the restrictions to FDI and immigration, both reducing economic growth potential; 5) economic burdens deriving from the increase in public and private debt; 6) economic, financial and political fragilities in the Eurozone, China, and other EMs; 7) the potential for bubbles to burst in many over-priced markets; 8) the potential for fire-sales to take place in increasingly illiquid markets; 9) a “wag-the-dog” political risk in the US; e.g. Trump embarking on foreign policy adventures in the lead-up to the 2020 general election; and, 10) the constraints, deriving from the rise of populist parties, that policy makers will face in using policy tools to counter a crisis.  

Populists of All Countries, Unite!

by Brunello Rosa

10 September 2018

Given recent developments, and paraphrasing the famous incipitof Karl Marx’s Communist Manifesto, we could start this column by saying: “A specter is haunting Europe - the specter of Populism.” In fact, the clear threat to the future of the European integration process is the rise of populist parties across the old continent. In spite of the proclaimed nationalism and “sovereignism” of these parties, their level of coordination is increasing, and is doing so with the help of external forces. In January 2017, France’s Le Pen, Italy’s Salvini, Germany’s Petry and Netherlands’ Wilders met in Koblenz to launch a sort of Populist International, forming an embryonic bloc of parties that would work to block, and possibly reverse, any further European integration process. In the subsequent Dutch elections of 2017, the party of Geert Wilders became the second largest party in parliament, achieving massive gains in votes and seats. In France, Marine Le Pen reached the second round during the presidential elections in 2017, where she lost to Macron. Salvini has now also entered into the government, as a Deputy Prime Minister; the AfD is now the main opposition party within the German Bundestag, having forced the CDU/CSU and the SPD again into forming an unnatural Grosse Koalition. The AfD is now, according the polls, the leading party in East Germany. In a recent rally in Chemnitz (ironically, the city in which Marx was born) AfD and Pegida (a far right, nationalist and racist movement) marched together to protest the killing of a German-Cuban man by two immigrants.

Meanwhile, Italy’s Salvini has also established a strong relationship with Hungary’s Orban, and sided with his Visegrad Group (together with Poland, Czech Republic and Slovakia and Hungary). Whereas populist Babis, as new Czech Prime Minister, has joined KaczyńskI’s  Poland. In Austria, the far right party FPO, led by Heinz Christian Strache, has also made it into government, where it holds crucial ministries in Kurz’s administration. Austria has in effect nearly become an additional member of the Visegrad Group. 


This quick recap of past events can help us to understand the most recent developments. In Sweden, for example, the Swedish Democrats gained in the elections held on Sunday 9th September, reaching 18% of votes and becoming an obstacle to the formation of any new majority government, possibly forcing mainstream parties into forming a grand coalition. 

Most importantly, Donald Trump’s controversial former advisor Steve Bannon has put together an organisation, called “The Movement”, based in Europe, the purpose of which is to coordinate the activities of all the “sovereignist” and nationalist parties that aim to promote European dis-integration. The first top-notch politician to join the movement is Italy’s Salvini. The Movement might be pursuing the same goals of Russia, in weakening Europe as a global geopolitical actor. And that could be Donald Trump’s own goal as well, in spite of the “Resistance” of the “Deep State” that may exist within the White House and the US government. All these developments are relevant not simply from a political and geopolitical standpoint, but also for their macro and market implications. 

The sovereignist movements might make large gains in the European elections held in May 2019, and by doing so influence the appointment of top officials of European institutions and block any further European integration efforts, in spite of Macron’s and others’ efforts. Just by way of example, European institutions have been critical to solving the recent euro debt crises (in the EZ periphery); thus, their weakness would imply a greater level of vulnerability for those struggling countries and for the EZ as a whole, when the next recession or crisis does occur. As the recent increase in the Italian BTP/Bund spread showed, financial market volatility due to political developments in Europe could contribute to uncertainty and macroeconomic and financial under-performance in the countries that they affect the most. 

Holidays Are Over: Resumption of Full Activity Brings Major Risks to the Fore

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.

U.S. Stock Market Record Is Welcome, But Still Suggests Caution


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.

The Turkish Crisis Deepens, Sending EM Stocks Into A Bear Market

by Brunello Rosa

20 August 2018

The Turkish crisis continues, and it does not seem likely to abate anytime soon. Last week Turkey’s Finance Minister Berat Albayrak announced that the country's government will reduce inflation by way of fiscal discipline and structural reforms. Meanwhile Turkey's central bank announced a new set of measures intended to support financial stability, including a 250bps reduction of reserve requirement ratios for all maturities and a 400bps reduction of non-core FX liabilities for selected maturities. At the same time, relations with the US have worsened since Turkey's President Erdogan doubled import tariffs on certain US products (in response to US President Trump’s initial move), US Treasury Secretary Mnuchin confirmed that more sanctions on Turkey are being considered, and a Turkish court rejected a new appeal for the American pastor Andrew Brunson’s release from house arrest. As a result of all of this, S&P and Moody’s both downgraded Turkey’s rating by one notch, and USD/TRY closed the week at 6.012 (-6.4% in the past week). 

As we discussed in recent reports, the risk of a full-blown crisis may rapidly become the baseline scenario for Turkey. Contagion risks have risen significantly, with European and EM funds continuing to suffer outflows. In the Eurozone, the Eurostoxx 50 closed 1.6% lower than it had the previous week, amid worries over Eurozone banks’ exposure to Turkey. Stock prices declined in emerging markets, with the MSCI EM index down by 5.2% from a week ago. EM stocks have now reached bear market territory; i.e. they have declined by more than 20% since their January peak.  With Argentina having resorted to accepting an IMF assistance program earlier this year, it would seem obvious that Turkey should or will soon do the same. However, given the tense relationship between Turkey and the US, asking for money from a Washington-based institution like the IMF, which is dominated by US voting rights, is politically toxic for Erdogan. As a result, Turkey is looking for other “white knights” to assist it, whether it be Russia, China, or  Qatar.  

Turkey's looking to the east for alternative sources of funding will have profound geopolitical implications. As discussed by John Hulsman in his most recent Geopolitical Corner, it could mean that NATO as we know it is now likely to be over; transatlantic relations will never be the same in the future as they have been to this point. This means the US can continue to disengage from the Middle East “reimagining itself as an off-shore balancer", according to Hulsman, "only getting seriously involved in the area if one of the many regional powers (Turkey, Israel, Egypt, Iran, Saudi Arabia) comes to dominate the others.” 

The Turkish crisis has already spread beyond its epicentre to affect other emerging markets. It could soon impact the more fragile developed economies as well, by way of exposure to banking channels. The ECB has already singled out Spain, France and Italy as warranting the most concern in this regard. Italy in particular is quickly approaching the end of the grace period that international investors were willing to give the new “populist” government ahead of its presentation of a budget at the end of September. The country better be ready for when this grace period eventually comes to an end.

Turkey’s Debacle and Wider Contagion Risks


by Brunello Rosa

13 August 2018

The Turkish Lira (TRY) collapsed last Friday, losing around 15% of its value against the dollar in a single day.  The Lira’s loss against the dollar has now reached almost 45% since the beginning of the year. 

We have been following Turkish developments very closely in the last few months, so this crisis did not come unexpected. On August 9th, we warned that the risk of a full-blown balance of payments crisis was rising, thus increasing the downside risks to the muddle-through scenario, which was considered until recently the most likely course of action (chiming with our previous analysis). The volatility we expected to increase ahead of the elections of June 24th, which gave President Erdogan increased political powers deriving from the 2017 constitutional referendum, has persisted even after the elections. This volatility has occurred especially as a result of statements and appointments made by Erdogan, which have reduced the independence of Turkey’s central bank (as discussed in our column on July 23rd) and the credibility of Turkey’s Ministry of Finance.

The repercussions of the Turkish crisis for international markets can be divided into two fronts: emerging markets (EMs), and financial markets in general. For the former, our working paper published today (Turkish Lira Tumbles, Contagion Risk Rises) suggests that contagion from Turkey to other emerging markets is increasing. The impact of Turkey on stocks in India, Brazil, Russia and South Africa has been marginally negative. In the fixed income space, 10-year government bond yields have increased in India, Russia, and especially Brazil (+28bps, to 11.76%) and South Africa (+17bps, to 8.86%). EM currencies have depreciated in China, India, Brazil, Russia and South Africa. This is the result of the increased fragilities we discussed in our recent EM outlook and strategic asset allocation paper.   

Somewhat more worrying, however, is the contagion risk that Turkey might pose to financial markets and economic performances in general, in particular via exposure to Turkish banks. As discussed in a recent press report, European banks (especially in Spain, Italy and France) own significant stakes in the Turkish banking sector, which in turn carry an exposure of more than USD 130bn to the Turkish non-banking private sector. In particular, three major lenders— France's BNP Paribas (holder of 72.5% of the retail bank TEB), Spain's BBVA (49.9% of Garanti bank) and Italy's UniCredit (40.9% of Yapı Kredi bank) lost 3.0%, 5.3% and 4.7% of their share value on Friday, respectively. The European Central Bank expressed concern about the three banks’ exposure to Turkey; the Turkish market accounts for 14% of BBVA’s total loans, 4% of Unicredit’s, 3% of ING’s and 2% of BNP Paribas’. 

This situation could be especially concerning for peripheral Eurozone countries, such as Italy, which are already the focus of investors’ concerns as a result of their own domestic issues. Italy’s “populist” government is in the process of drafting its first budget, even as it faces serious divisions within the governing majority. The Turkish crisis is yet another reminder of the interconnectedness of financial networks; of how a crisis in one area of the global economy can quickly affect wider markets.

The Flip Side of This Very Hot Summer

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.) 

Central Banks In Focus

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.

The Ongoing Challenge To Central Bank Independence

by Brunello Rosa

23 July 2018

The independence of central banks from political influence is one of the pillars of the world order as we know it. Central bank independence started to be granted in many countries during the 1980s, when central banks began to be tasked with the goal of achieving price stability (fiscal policy, meanwhile, remained mostly in charge of supporting economic activity). Since then, the benefits deriving from central bank independence have been evident in the structurally lower inflation rate that has occurred at a global level, which has contributed to lower long-term interest rates. Nevertheless, in the same way that other pillars of the post-WWII world order, such as NATO, the EU, and even the role of the US as the hegemonic global super-power, are now being questioned, central bank independence is also being challenged. One could even say that central bank independence is “under attack.” 

To a certain extent, the quantitative easing programs begun by the major global banks in 2008 were meant to blur the distinction between monetary and fiscal policies. The risk of “fiscal dominance” (i.e. the use of monetary policy to keep governments solvent) was contained solely by the fig leaf that those policies were “independently” adopted by central banks in order to pursue the banks’ price-stability objectives (e.g. by minimizing deflation risks). Also, it was inevitable that after this golden era of the central bank semi-godscoming to the rescue of the world economy – since fiscal policy was still constrained by anti-Keynesian ideological approaches – their apparent unlimited power would come under more severe scrutiny by the political authorities. But here we are not simply talking about central bankers returning to their traditional roles, by giving up the exorbitant powers granted to them in the aftermath of the Global Financial Crisis. Rather, we are talking about the return of political interference in matters that have traditionally been decided by central bankers, such as the right of independently setting interest rates. 

Examples of this new tendency are starting to become common. In Argentina, when the government increased the inflation target from the 8%-12% range to 15% at the end of last year, the central bank “found the space” (to use a euphemism) to cut rates at a time when inflation was not giving any sign of moderating. This upset international investors, who then sold the peso en masse, thereby forcing the government to go cap in hand to the IMF for a USD 50bn emergency loan. In Turkey, ahead of the elections that certified Tayyip Erdoğan’s acquisition of new presidential super-powers, Erdoğan himself explicitly said that he would reduce central bank independence, thus causing a sharp sell-off of the Turkish lira. After the election the president granted himself the power to appoint the new central bank governor, after choosing his son-in-law as head of the new treasury and finance ministry. 

Unfortunately, even in developed markets central bank independence is also not as sacred as it used to be. Last week U.S. President Donald Trump criticised the Federal Reserve’s recent decision to increase rates. Reportedly, Trump said: “I am not happy about it. But at the same time I’m letting them do what they feel is best […] So somebody would say, ‘Oh, maybe you shouldn’t say that as president. I couldn’t care less what they say, because my views haven’t changed. I don’t like all of this work that we’re putting into the economy and then I see rates going up.” It is worth reminding Trump of the experience of Fed Chair Paul Volcker, who in the early 1980s engineered a recession in order to combat inflation, and eventually succeeded in achieving his goal.  

Given the considerations above, it is certainly a possibility, but definitely would not be a welcome one, that a lack of central bank independence will become, together with populism, nationalism and rising authoritarianism, yet another ingredient of the new world “dis-order” we seem to be heading for.  

Trade Skirmishes And Technological Wars


by Brunello Rosa

16 July 2018

A series recently-published of articles (for example in the New York Times and Le Figaro) reported on the rapid development of facial-recognition and other surveillance technologies in China that allow the authorities (central and local governments, public administrations, school boards, etc.) to follow almost any moment of people’s lives, in a country with a population of 1.4 billion. The authors of these articles suggest how these systems are the technological evolution of other forms of social control that have traditionally characterised Chinese society for centuries, from household communities to workplaces. These surveillance technologies would also allow the government to finally implement a system of “social reputational scores” that was conceived in the 1990s as way of assessing people’s creditworthiness, only now expanded to take in a much greater scope.  

In schools, systems of continuous surveillance would allow the teaching board to make a complete, 360-degree evaluation of scholars, not just through traditional test scores but also by assessing the presence, participation and activity of pupils during school hours, interest in the subjects studied, and overall behaviour during examinations as well as during recess. This way, the authorities claim, only the best of the best (not just academically, but also in terms of behaviour) will emerge in a dramatically competitive environment such as Chinese society today. At the same time, it is quite natural to think that, with these technologies, governmental control of people’s activities (including those of a political, or politically-sensitive, nature) can also be more fully implemented and enhanced. 

Let’s set aside, for a moment, the moral, ethical and political implications of these technologies, which could amount to a rather dystopian, Orwellian big-brother future, where the combination of artificial intelligence (AI), Internet of Things (IOT), big data, robots and automation eventually lead to the emergence of a combined system of machines not dissimilar to the Skynet of the Terminator saga, which eventually becomes self-sufficient and auto-directed. (With some sense of humour, the Chinese police chose the name “Skynet” for their system of surveillance cameras). What is mostly relevant for us at this juncture is the fact that the new battlefield for world economic leadership is precisely within the perimeter marked by AI, IOT, big data, robots and automation. This technological battlefield also includes a geopolitical component constituted by the use of cyberwarfare, as well as a financial aspect deriving from the addition of Fin-Tech to the mix. 

As discussed in a recent report by Nouriel Roubini, in this race to the 21st century economic supremacy, China is ahead of any other country in the world, having set the goal of being the number one performer in the 10 most advanced technologies of the future (including AI, robotics, EV and driverless cars, biotech, aerospace, and others) by 2030, even using aggressive industrial policies that will include government funding, subsidies and below-market rates loans in order to achieve this goal. One can see how the ongoing trade tensions (with tariffs and counter-tariffs between US and China) are just skirmishes (that could still lead to a full-blown trade war, if not contained), compared to the much deeper and broader lingering technological war between the world’s super-powers.

Yield Curve Flatness Does Not Imply US Recession

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. 

EU Summit Yields Little Results, As European Crisis Intensifies


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). 

Q2 Ends With Some Hopes and Many Warning Signals

by Brunello Rosa

25 June 2018

This week the second quarter of 2018 will end, with some hopes and a few warning signals on the economic, financial and geopolitical front. From a macroeconomic perspective, Q2 saw a re-acceleration of growth in US economic activity, partly boosted by the tax cuts approved in January, while the soft patch that affected economic growth in the Eurozone, UK and Japan seems now to be a more persistent phenomenon than initially anticipated, in spite of recent better PMI data. As a result, while US inflation is now above target in both headline and core terms, core inflation remains subdued in the Eurozone and Japan, and is falling fast in the UK and is now just above the BOE target. China’s economy has performed decently in both Q1 and Q2, although recent data have been mixed and regulatory tightening in credit this year is likely to slow down economic growth. 

Central banks have reacted accordingly. The Federal Reserve has signaled that, unless something goes wrong, it will carry on with its policy normalization at the pace of one 25-bps increase in the Fed funds target range per quarter in 2018, with two additional hikes expected during the remainder of the year. The Bank of Japan has remained on hold this year and will likely wait much longer to review its policy stance, especially after the unexpected economic contraction in Q1. The European Central Bank, while announcing the tapering of its asset purchases, has signalled that the first rate hikes might not occur until Q3 2019. The Bank of England has postponed to at least August (if not later), the rate hike that most market participants (but not us) expected to occur in May. The PBoC cut the reserve requirement ratios for many banks after soft economic data and just announced a new round of cuts to deal with the expected growth slowdown from trade frictions.

The most vulnerable emerging markets have suffered from the combined effects of USD strength (in turn deriving from US rate policy normalisation, Fed’s balance sheet reduction and US Treasury’s increased issuance to finance the greater budget deficit created by the tax cuts), oil price increases (due to past cuts to production, partly eased at the latest OPEC meeting), policy mishaps and still-large current account deficits: top of the list were Argentina and Turkey. A number of EM central banks (in Argentina and Turkey, but also in Brazil, India, Indonesia, Mexico) have been forced to increase their policy rates or intervene in the FX market to defend their currencies against the USD appreciation. Oil exporting countries, such as Russia and Saudi Arabia, have done better, thanks to higher oil prices.  

From a geopolitical standpoint, most developments don’t seem particularly reassuring. Slightly easier tensions on the Korean peninsula, to the full advantage of Kim Jong-Un, have been more than offset by the beginning of a full-fledged trade war between the US and the rest of the world, starting from China, and including Canada and Mexico (with NAFTA being put on hold) and the European Union. In Europe, a new severe crisis seems inevitable, whether due to the lack of agreement on migrants, on fiscal policy or on Brexit. The new “populist” government in Italy is likely to be only modestly confrontational initially, but the truce with the EU and the markets might only last until the autumn. 

Markets have reflected those economic and geopolitical developments. As we expected, US equity prices have not returned to their January 2018 peak yet, and we don’t expect them to do so for the rest of the year. The 10y US Treasury yield finds it hard to go beyond 3% on a sustained basis, especially as long as the ECB and the BOJ continue with the asset purchases, depressing bund and JGB yields. This week, we will publish our asset allocation update, which will suggest how to position in this difficult environment. 

London Caput Mundi (for This Week)


by Brunello Rosa

18 June 2018

This week, the UK will stage a series of high-profile events. First of all, the House of Commons will continue to vote on the EU Withdrawal Bill, on the series of amendments that have been approved by the Lords and that the lower chamber has started to reject last week, including on the continued participation of the UK in the EU customs union or even in the single market. The most relevant front that is still open, on which there will likely be a vote on Wednesday, is the possibility for the UK parliament to have a “meaningful vote” on what the government should do in case of “no deal” between the UK and the EU. 

Last week, the Commons rejected the original amendment by the Lords by 324 votes to 298, i.e. with a majority of 26. This means that when the bill returns to Commons on Wednesday, only 14 Tory MPs would have to change their vote to defeat the government. It is estimated that there are currently around 15 pro-Remain Tory MPs that could vote against their own government. If that occurred, Theresa May’s negotiating strategy might need to change completely, as it would be enough for the EU to reject any deal (however advantageous for both sides) to create turmoil in the UK and de-facto postpone Brexit indefinitely. 

As discussed in our recent analysis, the post-Brexit customs arrangements are far from being simple technical commercial options and mask instead deep political choices that the country needs to make, also to preserve its territorial integrity. The risk is of course that the country makes no clear choices, goes un-prepared to meetings (including the June 28-28 EU Summit) and will undergo a few more rounds of political turmoil, before entering a permanent limbo or – worse – falling down a cliff-edge.  

All this would have serious implications for the UK economy, which will be discussed at the Mansion House dinner on Thursday, when both BOE Governor Carney and Chancellor Hammond will speak and provide their views. Carney will speak just a few hours after having concluded its Monetary Policy Committee meeting, which we – in line with the market – expect to be concluded with an unchanged policy stance. However, this meeting will be important for two reasons. First, it will conclude the summer round of G4 central bank meetings that started last week (with the Fed, the ECB and the BOJ) and will help us taking stock of how global central banks are currently seeing the world and their domestic economies. Secondly, it will be the last meeting before August, when the BOE might be carry on with its stated plans, and increase its policy rate by 25bps to 0.75%. Hopefully the language of the statement will shed some light on the BOE’s current inclination in favour of further tightening, given the recent fall in headline inflation (to 2.4%, from the 3.1% recorded as recently as in November 2017). 

Even if the BOE rightly keeps its decision-making process separate from the day-to-day Brexit developments, it is clear that, if something goes horribly wrong between June 2018 and March 2019, BOE’s policy actions will be the first line of defense (including for the GBP), as it was the case in the aftermath of the June 2016 referendum.

Central Banks Return to Centre Stage

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.

G8, G7, G6+1 and ?

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. 

Yet another European Crisis is Looming

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.   

US - China Trade War On Hold For Now, But Strategic Rivalry Likely To Continue

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.

Italy’s Government Puzzle About to Be Solved (One Way or the Other)

by Brunello Rosa

14 May 2018 

After more than two months after March 4th general election, Italy’s government puzzle is likely to be solved in the next 2-3 days, although we still don’t know the exact details. Until a week ago, it seems that Italy was destined to have a politically “neutral” government, led by a technocrat appointed by President Mattarella, to take the country to new elections in July or September 2018, or – at the latest – March/May 2019. This government would have run as a minority government, with or without a confidence vote from parliament (in the latter case, it would have been only in charge of current affairs). Parties in parliament got scared of a possible election at the end of July, when the collapse in turnout would likely imply a random result, and an assured punishment to those parties that were unable to find a compromise for months.  At that point, Five Stars and League took the lead – with the benevolent consent of Berlusconi’s Forza Italia – and started negotiations (which are still ongoing) to form a government between the two. In theory, this Five Stars- League coalition government (which we discussed in our comment after the elections) could count on a relatively solid majority in the Chamber, and a quite thin majority in the Senate. 

At this point, there are two main possibilities: 1) Less likely - M5S and Lega do not succeed in finding a compromise, especially on the name of the prime minister, acceptable to Mattarella. This would mean the failure of any attempt to form a political government, and the return of the “neutral” government option on the table, which would be formed this week, with new elections likely to occur relatively soon; 2) More likely - M5S and Lega do succeed in finding a compromise, especially on the name of the prime minister, a “third” figure between Matteo Salvini and Luigi Di Maio – both likely to be part of the government team (possibly as Interior and Foreign minister, respectively).  

So, by the end of this week Italy is likely to have a new government, one way or the other. A few considerations: First, a “neutral” technocratic government is better than the current situation, in which Gentiloni’s administration (however good it might be in people’s opinion) is expression of the past parliament, with no political legitimacy (and in fact only in charge of current affairs) and unable to make politically binding decision. Also, technocratic governments have often represented a good solution in difficult political and economic transition periods. However, we would be inclined to think that, in this case, even a weak political government would be preferable to a technocratic solution, which would be unlikely to find the necessary legitimacy in parliament and the country to make politically strong and binding decisions such as those the country needs to face in coming months (starting with the June EU Council meeting). 

Second, a M5S-Lega government would face a number of obstacles to succeed, including: a) unless Salvini and Di Maio agree that one of them becomes PM (or possibly both, in succession), the “third figure” would be subject to continued and opposed political pressures from both side; b) the “government contract,” instead of being the “intersection” between Lega and M5S’s respective programs, seems to be the “union;” so, for example, both the “citizenship income” and the “flat tax” are there, not to mention various forms of reduction/abolition of the pension reform approved by Monti in 2011. This means that implementing this program would likely imply a severe deviation from Italy’s fiscal consolidation program, likely resulting in a clash with markets and the EU at some point; c) Salvini – as still being formally part of the centre-right coalition – will tend to remain more loyal to that coalition than to that with Di Maio’s Five Stars. 

Given this background, we reiterate what we said in our latest Italy trip report. While in the short run we believe the country has the means to muddle through, without clashing excessively with the EU and the markets, in the medium term (especially once the ECB’s umbrella will be diminished), its structural fragility will likely re-emerge.  

Emerging Markets Face Tough Test of Resilience

by Brunello Rosa

8 May 2018 

By the end of the week (most likely on Tuesday 8th May, with a self-imposed deadline on May 12th), the US will decide whether or not to withdraw from the Iran nuclear deal. To force the hand of its historical ally, Israel’s PM Benjamin Netanyahu, in a recent press conference, said that Iran has lied regarding its compliance with the agreement, having continued to develop military nuclear capabilities. If Israel decided to launch airstrikes on Iran’s nuclear sites at the time the US decides to re-impose (at least part of the) sanctions on the same country, this could represent a quite substantial risk scenario that could cause a spike in oil prices, which have been rising in the last couple of years (and have now reached 70 USD per barrel, for the first time since 2014) thanks to the production cuts agreed between OPEC (and in particular Saudi Arabia), and Russia. In our recent outlook for oil prices over the 2018-2020 horizon, we discuss in detail this and other (risk and baseline) scenarios.

Geopolitical risks (with perhaps the exception of the Korean situation, which might enter a period of reduced tensions), increasing oil prices, softening growth, rising U.S. Treasury yields and strengthening US dollar constitute a dangerous mix for emerging markets, whose most fragile components have already started to suffer. 

Last week, the Argentinian central bank had to increase rates again (outside scheduled meetings, for the third time since April 27th, for a cumulative amount of 12.5% to 40%) to stem ARS depreciation versus the USD. This was due to the decision of cutting rates in January 2018 (at a time inflation wasn’t giving signs of moderating from the current 25%) as well as of moving the inflation target upward, from the 8-12% range to 15%, once the objective was missed and appeared unlikely to be reached in the foreseeable future. In our recent report, we discussed the dangers associated to central banks moving the goal posts when they felt they could not reach their inflation targets. Turkey was also at the centre of investors’ concerns last week, with the USD/TRY having increased by almost 5% in a week to 4.23, on the back of the S&P’s credit rating downgrade and rising inflation, in the context of upcoming general elections, still-large current account deficit and a high and rising stock of external debt. 

Market participants are now braced to see whether these cases will remain idiosyncratic episodes or will prove contagious for the entire EM space. Some oil-producing EM economies (e.g. Russia) would certainly benefit from the rise in oil prices. We have argued in the past that a number of EM currencies were able to better withstand US rates normalization, thanks to improved macroeconomic fundamentals and also noted how EMs proved quite resilient during the market correction in February. In the next few days and weeks we will see whether or not EMs have in fact sufficient stamina to weather this period of increased investor nervousness.  

Market Prices Re-Aligning to Economic Fundamentals and Policy Differentials

by Brunello Rosa

30 April 2018

Last week’s column discussed how uncertainties on the solidity and durability of the ongoing global expansion were keeping central banks more cautious than otherwise they could be, given the stage of the business cycle. We correctly predicted that the ECB’s Governing Council would discuss the soft patch the EZ economy is experiencing (in this respect – watch this week’s Eurozone Q1 GDP growth, inflation and unemployment data), that the BOJ would keep its policy stance unchanged, that the Riksbank would postpone the timing of its first policy rate increase. We also reiterated our view that the BOE would be more likely to raise rates in August than in May, and the preliminary reading of Q1 2018 GDP (which came in at +0.1%, versus 0.3% expected, and declining from the 0.4% recorded in Q4 2017) makes a rate hike on May 10th quite unlikely at this stage. 

On the other hand, the US economy last week exhibited data that came in above expectations on March retail and home sales, and in particular Q1 2018 GDP which featured a 2.3% q/q annualised growth (compared to a consensus view of 2% - but decelerating from the 2.9% recorded in Q4 201). This data came out ahead of this week’s FOMC meeting, which we expect (in line with consensus) to result in unchanged policy, ahead of a further increase in Fed Funds target range in June. The statement accompanying the decision is likely to signal the upcoming further incremental tightening in early summer.

On the back of these data and policy divergence, the USD rose against a basket of currencies (DXY was up by 1.3% on a weekly basis, its second largest weekly gain in 2018), EUR/USD declined by 0.8% to 1.213 on a weekly basis and GBPUSD fell significantly below 1.40. The UST 10-y yield remained unchanged on the week (at 2.96%), after having crossed the 3% level for the first time since 2013. Some technical analysts would suggest this could be the beginning of a bear market in bonds. We believe that as long as Bund and JGB long-term yields remain this low, also the long end of the US Treasury curve will remain anchored.

A stronger dollar would help other DM central banks to reach their inflation target, and so last week’s moves were likely welcomed across the board. This was probably less true for EM economies, which tend to experience capital outflows when the dollar strengthens. However, as we discussed in a recent analysis on EM currencies, EM countries are now more resilient to US policy normalisation, in spite of the notable rise in private-sector debt, even denominated in USD (the exception could be Argentina, where the central bank last week was forced to increase rates intra-meeting by 300bps to 30.25%, to prevent a slide of the ARS versus the USD). All this to say that when market pricing follows economic fundamentals and policy differentials, the life of policymakers is easier. Unfortunately,  this alignment has been the exception rather than the rule recently, with USD weakening is spite of the fiscal stimulus and higher monetary policy rates. The next few weeks will tell whether this re-alignment will continue or not. 

Central Banks Remain Cautious as Clouds Gather on Global Expansion

by Brunello Rosa

23 April 2018 

At the IMF/World Bank Spring Meetings just concluded in Washington DC, the mood was still relatively upbeat, as the synchronised global expansion continues. At the same time, IMF MD Christine Lagarde, on the eve of the meetings said it quite openly: dark clouds are starting to gather on the horizon, especially as a lingering trade war threatens the global economy

In our recent reports, we looked at this and other threats: in our scenario analysis on the US-led airstrikes on Syria, we discussed the geopolitical risks building up in the Middle East. In our report on the ECB and Eurozone, we discussed the macroeconomic risks deriving from the plateauing of growth in the Eurozone, which is becoming evident in some hard data (e.g. industrial production, exports) and leading indicators (e.g. composite PMIs). Our trip report from Japanhighlighted the macroeconomic (persistently low inflation), geopolitical (developments in the US-North Korea relationship) and political (Abe’s shaky position) risks prevailing in the country. Finally, our trip report from the UK looked at the consequences on fiscal and monetary policy deriving from Brexit developments. In the upcoming Italy trip report we will discuss the rising political risks that could eventually pose a threat to the European integration process. 

To summarise: the world economy is doing fine, but risks exist, and their materialisation could turn the global expansion into a global slowdown in coming quarters, and eventually into a contraction, in some selected countries and regions. 

So, how are policy authorities reacting to this changed environment? The sentiment prevailing among central bankers could be summarised with one word: prudence. The BOE, on the back of inflation falling more than expected, is now putting into question the rate hike the market was expecting to occur in May. The ECB will eventually finish its net asset purchases, but at the IMF meetings Mario Draghi made it clear that “an ample degree of monetary stimulus remains necessary for underlying inflation pressures to continue to build up.” The BOJ, on the back of the macro, political and geopolitical risks mentioned above, appears to be willing to keep its policy and communication unchanged for at least another year. The Fed is, for the time being, the only central bank of the big four, that seems ready to continue with its policy normalisation program: but three hikes in 2018 seem more reasonable than the four that some market participants expect.

But once again: central banks cannot be the only policy game in town. Other policy areas need to do their part to make the world a better and safer place – fiscal authorities, regulators and governments at large. Diffusing dark clouds on the horizon is a collective exercise, which cannot succeed unless there is broad domestic and international policy coordination. 

Red Lines or Red Flags?


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. 

Trade War Fears Continue Weighing on Investor Sentiment


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. 

Q1 Proved to Be a Challenging Quarter - Q2 Won’t Be Much Easier

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. 

Who Checks On “The Boss” in Washington?

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.  

The Rise of Authoritarian Leaders: A Downside Risk to the Global Economy

by Brunello Rosa

19 March 2018


On Saturday, the Chinese parliament re-elected Xi Jinping as President of China, while a week before the constitution was amended to allow Xi to remain in power indefinitely. Xi’s choice of Wang Qishang (a key ally of Xi who was in charge of the anti-corruption campaign) as vice-president also signals the intention of the president to continue consolidating and concentrating the power in his hands. China exhibits a number of socio-economic fragilities, but the system as a whole has the economic and financial resources to withstand a systemic crisis. With the latest consolidation of power, the president has ensured that China could even face an additional systemic crisis and be able to preserve the integrity of the political system. 

On Sunday, Vladimir Putin was re-elected Russian President for his fourth mandate, which will last six more years, until 2024. At the end of this term (assuming he does not change the constitution to remove the clause that prevents a third consecutive mandate), he would have been in power (as President or Prime Minister) for 25 years. After Putin’s accession to power, Russia has rapidly moved from a presidential democracy, albeit imperfect, to an increasingly autocratic regime. The annexation of Crimea in 2014 shows how cynically Russia could move on the international stage. 

In April 2017, a referendum in Turkey has transformed the Republic into a Presidential system, in which President Erdogan is the deus ex machina. Also Erdogan has been in power, initially as Prime Minister and then as President, since 2003. Since Erdogan’s accession to power, also Turkey has moved from being an imperfect secular democracy to an increasingly Islamic-inspired autocracy, as testified by the repression that followed the failed coup in July 2016. 

Russia and Turkey are two examples of the increasing tendency of political systems to evolve from relatively democratic organisations into autocratic regimes, and other could be made (e.g. the Philippines under Rodrigo Duterte). China shows how power can be further consolidated and concentrated even in already authoritarian regimes. Statistics show (see map above) how this phenomenon is increasingly happening throughout the world.

The recent crisis of the Russian spy killed in the UK, which has led to the summoning of a UN security council meeting, show how dangerous can be the rise of authoritarian regimes: they represent a problem not just from a (geo)political perspective, but also from an economic perspective, if this leads, for example, to the imposition of economic sanctions. In fact, sanctions tend to have negative repercussions not just on the target country, but also on all those countries linked to the targeted one via trade and financial flows. 

Therefore, the rise of authoritarian regimes in a period of increasing protectionism (which is also a typical move adopted by autocratic leaders) represents not just a danger for the already fragile and shifting world geopolitical order, but also a downside risk – over the medium term – to the sustainability of the ongoing synchronised global expansion, and related equity valuations. Market participants tend to underestimate the importance of such political shifts, as they occur slowly and their effects tend to be felt overtime, or because they are perceived only as tail risks, even when they carry a potentially large downside. Nonetheless, historical experience show that the cumulative impact of such political shifts tend to be large, when they materialise.

US Tariffs: The Return of Protectionism and Trade Wars?


by Brunello Rosa

12 March 2018  

The announcement of U.S. President Trump to introduce tariffs on import of steel (25%) and aluminum (10%) follows by only a few weeks Treasury Secretary Steve Mnuchin’s statement (subsequently softened) that a weak dollar would be good for the U.S. and marks a new element of discontinuity with the economic international order that the U.S. themselves have contributed to build in the last few decades, based on multilateralism and a free trade/free market doctrine. 

Once again, the clearest (analytical) response from Europe came from ECB President Draghi, during the press conference following ECB’s Governing Council in March, when he said that this latest move by the U.S. administration was dangerous from a number of perspectives: (1) it seems reintroducing the concept that decisions on international trade can be taken unilaterally rather than multilaterally; (2) it opens up the risk of retaliation by the affected countries (3) it could have a long-lasting impact on confidence able to derail the global recovery; (4) it introduces elements of geopolitical uncertainty, because, if this is how the U.S. treats its “allies,” how is it going to treat its “enemies?”; (5) it might represent another another leg of the “lingering” currency wars discussed in our previous column. In fact, protectionism could result into the strengthening of the dollar if the Fed normalises its monetary policy faster than previously to counter increasing inflation due to tariffs; but tariffs could also result into a weaker dollar if they signal a "policy view” on desired dollar weakness, if they cause retaliation and if they change the investors' perception about how safe and attractive US assets are. 

There are various reasons why Trump might be launching such a dangerous initiative. On the one hand, he continues speaking to his own electorate, by saying that tariffs will help protect jobs and factories in the U.S. (even if the actual effect is likely to be the opposite), ahead of mid-term elections later this year. It is also possible that President Trump is using these tariffs as a negotiating tactics on other tables: for example, the decision to carve out Canada (the largest exporter of steel to the US) and Mexico from the tariffs is a signal sent to the two countries with which the U.S. is re-negotiating NAFTA: if they “behave” in those negotiations, they will be exempt from the tariffs that the U.S. is now imposing on other economies. If they don’t “behave,” they will also be included in the list of affected countries. 

The main concern about these developments is the potential for retaliatory actions, in particular from the EU, the bloc of countries mostly affected by this decision. Unfortunately, history teaches us that when the world goes down the route of increased protectionism and currency wars at the time the political scene is dominated by autocratic leaders, the endpoint is not a favourable one: at the very least, we could see a reduction in global trade, which could pose a sudden halt to the ongoing synchronised global expansion and eventually a reduced global output potential (as globalisation might have increased inequality within countries, but has also dramatically reduced differences in economic performance between countries). 

But things can go even more wrong, if we add a geopolitical dimension. Protectionism tends to create spheres of influence, and with them geopolitical fault-lines and tectonic plates that eventually collide, if not appropriately governed. At the time in which the UK is leaving the EU, Italy observes the rise of populist parties, and the 2019 European elections are likely to stage again the success of anti-system movements, we seriously run the risk of witnessing a further shift of the global macro and geopolitical situation towards the danger zone.

Europe Between Germany’s Renewed Stability and Italy’s Political Shift

by Brunello Rosa

5 March 2018  

As we wrote last week, the 4th of March proved a crucial day in European politics. Germany found some temporary stability with the result of the referendum among SPD party members, who approved with a relatively large majority of 66% the Grand Coalition between the SPD and CDU/CSU. This opens the door to Angela Merkel’s fourth term in power, which might not last the entire four years of parliament (6 months of which have already passed in negotiating the new coalition contract), but should last at least two years, perhaps before Merkel’s accession to a top European job in 2019. 

On the other hand, following its general election, Italy observes a massive political shift, whose extent will become clearer in coming days. As it takes time to translates votes into seats, thanks to the complications of the new electoral system, some facts are starting to emerge: 

1) The Five Stars Movement (M5S) emerges as the first party in Italy, with around 30% of votes; 

2) The centre-right emerges as the first coalition, with around 35-37% of votes; 

3) Within the centre-right coalition, the League (with around 18%) has more votes (and perhaps seats) than Forza Italia;

4) The PD collapses to around 20% of votes, if not below, and its coalition is unlikely to reach 25%.

We have discussed at length in our in-depth analysis what would be the options emerging from such a scenario. 

At this stage (but again, scenarios might change in coming days, when the distribution of seats will be clearer and the positions of parties more definite), we could envisage three main options: 

a) A centre-right government led by Salvini, with seats missing to reach a majority found in parliament among other parties;

b) A M5S-led government, with the potential support of Lega;

c) Less likely, a sort of “coalition of losers” between PD and Forza Italia, plus centrist parties.

All these options, as mentioned above, represent a massive political shift from the current political equilibrium, whose pillar was represented by the pro-European policies of the PD. Italy will now likely have a government whose attitude towards Europe, in terms of fiscal stance and other sensitive themes such as migration, much more confrontational than before. The market might not initially like this new approach, even if – in case it proved stable – might get used to it. In our analysis, we highlighted this risk that has now materialised: a massive shift towards Euro-sceptical forces.

So, the future of the European integration process is now much less certain: as long as Germany was mired in its own political mess, all other countries had some time for a bit of “respite.” But once a new, fully legitimised, government will be in place, it is likely that Germany will join France in its effort to reform Europe, perhaps with a slightly less austere fiscal stance. What will be Italy’s position in this process is yet to be determined. The government is now much more likely to be led by Euro-sceptical forces, so Italy’s position might be much less pro-European than before, putting any further integration at risk.

March 4th, 2018: The Day of Reckoning for European Politics

by Brunello Rosa

26 February 2018  

At the end of this week, we’ll know something more about the future of the European integration process, as the results of the referendum among the SPD party members on the proposed Grosse Koalition (GroKo) with the CDU/CSU and of the Italian general elections will be known.

The conventional narrative says that the SPD will eventually give green light to the GroKo, and that Italy will manage to find a parliamentary majority for a new government to emerge, even if this means that political forces that fought on opposite sides during the electoral campaign (in particular Forza Italia and PD), will have to find a compromise and form what would look like the Italian version of the German GroKo. The result of these expected outcomes is that the European integration process will re-start, with some progress made between the EU Council meetings in March and June. We don’t disagree that this could in fact be the eventual outcome, although we have already warned that any further integration step will be minimal at best, at this stage. We have also identified an upside scenario in which this process is accelerated by Merkel’s accession to a top EU job (head of the Commission or head of the EU Council) in 2019, while Macron continues to pushed on its pro-European platform at a national level.

At the same time, we have also highlighted the risks surrounding this conventional narrative. Regarding Germany, as we wrote in the inaugural column for this Viewsletter (on 4 December 2018), the risk is that of finding a short-term solution while creating a long-term problem, meaning a further collapse of the SPD (as junior party in the GroKo) and a further fragmentation of the German political system, with continued growth of Die Linke, the AfD and FDP, making Germany virtually ungovernable three-four years from now. The polls have recently shown that the voting intentions in favour of the SPD have already collapsed, to 15-16%, i.e. below that of the AfD, which in the meanwhile have increased. It is true that the SPD, having won the places for both the Finance and the Foreign Ministers will have greater chance to influence the policies of the GroKo, in particular its fiscal stance. But while the SPD in the Finance Ministry can at the margin make Germany’s fiscal stance less rigid and more investment prone, it’s unlikely to be able to make the final push for the EU/EZ to become the full-fledged transfer union it needs to become in order to survive in the long run.

Regarding Italy, we have written that there is still too much complacency in the market, given the level of uncertainty on the eventual outcome. Even the EU Commission President Jean Claude Juncker has expressed similar concerns last week, before moderately backtracking when accused of interfering in domestic political matters. But the uncertainty of the outcome is a fact. An untested electoral law, a record-high level of expected abstention and undecided voters, the fragmentation of the political system means that nobody can say with any level of credibility what the eventual distribution of seats will be, and therefore what parliamentary majority will eventually emerge to support a government. It is well possible that a protracted period of political uncertainty following the election will keep markets nervous about Italy, penalising its sovereign debt and bank equity prices.

March 4th will be an important day for Europe: If events unfold broadly as expected, the European integration process could re-start and progress in its usual bumpy way, muddling through economic and political difficulties. If instead events unfold differently, the process will likely suffer a sudden and protracted stop, which will take time to reverse.

Volatility Abates But Inflation Fears Will Continue to Weigh on Markets

 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.     

Emerging Markets Remain Resilient in Global Market Shake-Up

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. 

Higher Yields and Lower Equity Prices: Be Aware, Not Scared

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.

Lingering Currency Wars


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.

"War & Peace" - What Europe is Still About


by Brunello Rosa

22 January 2018

In its monumental novel “War & Peace,” the Russian author Lev Tolstoy narrates the French invasion of Russia by the Napoleonic army and provided a powerful fresco of what Europe was about in the 19th century: divided by profound fault-lines, always on the verge of a new devastating conflict, pressured by the ambitions of the Russian empire, the grandeur of the French Monarchy or Republic, the influence of Great Britain (at that time, half in and half out of Europe, like today), the attempt of Germany (back then still not existing as a united country) of projecting its political influence beyond being an economic powerhouse. 

Fast forward 130 years, after several intra-European conflicts between the continental super-powers, two devastating World Wars, both commenced in Europe (WWI with the assassination of Archduke Franz Ferdinand in Sarajevo), the European Union was created to put under the same roof the countries that had fought each other for centuries, slaughtering millions of people in the process. The European Union has made possible 70 years of peace in Europe (recognized by the Peace Nobel Prize of 2012), interrupted by the Soviet invasions of Hungary (1956) and Czechoslovakia (1968) and the American-led war against Serbia in 1998, when Kosovo was trying to become independent in the late 1990s. 

Twenty years later, we are approaching the moment of a potential breakthrough, with the accession of the Western Balkans in the European Union, beginning with Serbia and Montenegro. In early February, the European Commission is expected to publish a strategic paper, recommending that Serbia and Montenegro could become EU members by 2025, if a number of disputes are resolved in the meanwhile. In particular, Serbia needs to recognise the independence of Kosovo, as a pre-condition for EU accession. That would mean taming the narrative of Kosovo as the cradle of Serbian ethnical and religious beliefs.  

Just three weeks before this historical moment, the killing of Oliver Ivanovic, the leader of the Serb minority party in Kosovo, risk jeopardizing the entire process, as the Serb delegation walked away from the talks with the Kosovan delegation in Brussels. This politically-motivated murder could send Serbia back into the arms of the historical ally, Russia, and away from its European future, and could be the trigger of another wave of ethnical and political instability in the region. On the other hand, if the Serbian pro-European leadership keeps its course, it might accelerate the process of EU accession.

The EU was created to reduce the fault-lines that characterise Europe and resolve tensions and conflicts of interests among countries in a peaceful, rather than bellicose way. In our recent publication we discuss how the various countries are positioning themselves in the race to the top positions of European institutions, becoming available from March 2018 until the end of December 2019, with the European parliamentary elections in 2019. The men and women that will take those top positions will determine the future of the European integration process, and whether that can survive for longer or will eventually collapse. For the process of integration to re-start, the Franco-German engine also needs to be re-started, with France now seemingly in the driving seat. The window to reform Europe is narrow, perhaps closing between June and September 2018, with Italian elections in between potentially delaying important decisions. 

In a recent paper, a group of European economists has proposed a new solution to address one of the most contentious issues about the future of Europe, i.e. how to make sure that risk sharing does not become risk shifting, and therefore market discipline is maintained. In a recent event held at France Stratégie a number of representatives of continental institutions gathered to discuss the next wave of structural reforms, to make the European project viable also in the future and acceptable to the wider population, in order to prevent or sterilise the ongoing populist backlash. This is Europe as it needs to be – a common place where to discuss and resolve potential conflicts as well as clashes of interests and cultural approaches in a peaceful way. Because the alternative is a return of the scenarios so dramatically depicted by Lev Tolstoy in his epic book.   

A Bumper Start of the Year Still Requires Some Cautiousness

by Brunello Rosa

15 January 2018  

The year has started with a continuation, if not an acceleration, of the trends and dynamics observed in 2017, especially in the second half. Global growth remains in a cyclical upswing, with some of the leading indicators (such as PMIs) suggesting a continued and reinforcing expansion. Inflation has not yet raised its ugly head, and – as long as it remains in check – will not derail the upturn. As a result, monetary policy can remain accommodative at global level, even if and when central banks start withdrawing some of the extraordinary accommodation provided in the last few years. For example, in our latest paper, we discuss the central bank of Canada’s likely next move, and its possible tightening cycle in 2018. 

Fiscal policy is adding fuel to a maturing business cycle, especially in the U.S. where the tax cuts have further boosted sentiment and animal spirits (even if the eventual impact on growth will likely be more modest than initially anticipated). Some of the uncertainties that were restraining market sentiment, such as that around the formation of the German government, are now starting to be resolved, even if it will still take a number of months for the new “grand coalition” to emerge. In Europe, Italian elections are still a risk factor, but unlikely to cause an immediate resurgence of the re-denomination risk, and Catalonia-related issues don’t seem to bother investors excessively.

Given this background, risk is “on” context and equities have had the best start of the year since 2003, with the U.S. leading the race. The modest rise in short and long-term yields observed in the last few weeks, with the 2y U.S. Treasury yield having reached the psychological barrier of 2% and the 5y and 10y yields having broken 25-year trend lines, seems more in line with this generalised optimism, than an indication of a new “tantrum,” even when big players call for the end of the secular bond bull market begun in the 1970-‘80s.

Is this all “hanky dory” then? As discussed in our Global Economic Outlook, 2018 would likely see a continuation of the smooth sailing observed in 2017, with a potential for upward surprises in coming weeks, while cautioning that the risk of headwinds was rising (the way we put it is that “we are in the 5th inning of the credit re-leveraging cycle, not in the 8th as we were in 2006-07”). In our scenario analysis, we identify the risks to confidence, economic activity and market prices deriving from an abrupt tightening of global financial conditions (for example led by the closing of the output gaps in several developed and even developing economies), escalating trade restrictions and rising geopolitical tensions. In its latest Global Economic Prospects the World Bank, while acknowledging the ongoing growth momentum, identifies similar short-term risks to the economic outlook.   

Neither Permanent, Nor Temporary, But “Persistently” Low Inflation

by Brunello Rosa

8 January 2018

In a column of a few months ago, Nouriel Roubini discussed the potential factors behind what he called “the mystery of the missing inflation”, i.e. the fact that inflation was undershooting central banks’ objective in most areas of the advanced world, including those in which the output gap is closed, or very narrow, such as the US. In particular, he referred to the various persistent supply- side phenomena that can lead to a prolonged period of low inflation, including technological advancement, globalisation, new forms of labour organisation (and associated weakness of the unions and flatness of the so-called Phillips curve, which supposedly links unemployment and inflation rates). 

A week later, Fed Chair Janet Yellen also used the same term (“mystery”) to acknowledge that inflation have been undershooting the Fed’s 2% target for quite some time, while attributing this phenomenon to a series of temporary supply factors, such as reduced mobile phone bills and medical insurance premia, the long-lasting effects of lower oil prices, etc. Given their temporary nature, the Fed could look through those factors, and continue its monetary policy normalisation cycle, as in fact it did with the additional 25-bps rate increase delivered in December 2017. But before that, Yellen herself started to express some doubt on the temporary nature of this inflation under-shoot, when in a discussion at NYU, she declared: “We expect [inflation] to move back up over the next year or two, but I will say I’m very uncertain about this.” It is too early to say that the Fed will make a U-turn on this issue, but at least the debate in openly on the table.

In our recent 2018 Global Economic Outlook, we made a further step in our analysis of this phenomenon, when we argued that we don’t think that inflation is low either for a series of temporary factors, or due to the presence of permanent phenomena, such as the “death of the Phillips curve.” Rather, we think that inflation is low for a series of “persistent” supply- side (and some demand-side) phenomena, that conjure to keep inflation low for a long period of time, but unlikely forever. We believe that the global and technological factors that have kept inflation low so far are somewhat persistent and that these global factors matter for traded goods inflation but less so for non-traded goods inflation. 

Thus, in the debate between those at the Fed who believe that the supply-side shocks were mostly temporary and those who believe that they are mostly permanent, we argue that reality is in between, the shocks are neither permanent or temporary but “persistent” over time. As a result, in spite of stronger growth, inflation may rise only gradually rather than surprise to the upside in 2018, and the Fed may thus hike less than signalled by the “dot plot” but more than market participants currently expect.

Italy: A Year of Living Dangerously

by Brunello Rosa

2 January 2018

At the end last year, Italy’s President Sergio Mattarella dissolved parliament (a few months ahead of the natural end, in mid-March), to allow general elections to be held on March 4th, 2018. The Italian general election is the most relevant political event of the first quarter of 2018, if we assume that Russian presidential election will end up with the victory of President Putin (with effectively no rivals). 

This election will likely mark the beginning of a period of renewed political instability for the country, after a few years of relative calm, in spite of the four Prime ministers since 2011 (Monti, Letta, Renzi and Gentiloni, none of which formally mandated by an electoral result). In fact, since the fall of Berlusconi in November 2011, various forms of “grand coalition” between the PD and Forza Italia and its derivatives (in particular, the New Centre-Right founded by Berlusconi’s former dolphin, Angelino Alfano) have warranted a majority in parliament to pass tough legislation on various fronts: pension, labour market, public administration reform, two new electoral laws, and even a constitutional reform that was eventually rejected by the referendum of December 2016. 

But the new electoral law is less likely to produce a majority, unless a coalition reaches around 40% of the votes (which, depending on vote distribution) might result in a 50% majority of seats in parliament. At the moment, only the centre-right coalition led by Berlusconi’s Forza Italia seems able to reach that result. But even if that happened, the divergence in programs between Forza Italia, Northern League (now only called League) and Brothers of Italy (a radical right-wing party) wouldn’t warrant any stability in government. 

If no coalition manages to obtain a majority in parliament, then it will be Mattarella’s job to try to form a government and find a majority in the Chambers. His predecessor Napolitano succeeded in that, not without raising some eyebrow of constitutional experts. A “President’s government” (or a variant of it) would start by ensuring full continuity in Italy’s journey towards fiscal consolidation, by appointing a technocrat as Finance Minister, able to reassure the market. In this case, the incumbent Finance Minister Pier Carlo Padoan might remain in charge for a bit longer, to ensure continuity. But the market will remain skeptical of a government without a solid political mandate. A new round of elections might be necessary after only a few months. 

In all this, BTPs will continue to enjoy the backstop of ECB’s QE, but at a reduced pace, at the time banks are also offloading some of their BTP holdings (to comply with European and BIS requirements) and NPLs will continue to weigh on banks’ balance sheets. This cocktail of events seems spicy enough to justify market participants’ attention towards Italian elections in early March.

R&R 2018 Outlook: Smooth Sailing for Now, With Headwind Risks Rising

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.

Catalonia: an Open European Question

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) 

Brexit vs Grexit: Why The Negotiations Will Remain Bumpy

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. 

Is a German “Grand Coalition” Necessarily Good News?

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.