WEEKLY COLUMNS (ARCHIVE)

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By Brunello Rosa

2 September 2019 

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

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

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

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

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

By Brunello Rosa

27 August 2019  

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

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

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

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

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

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

By Brunello Rosa

19 August 2019  

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

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

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

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

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

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

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

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

By Brunello Rosa

12 August 2019  

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

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

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

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

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

By Brunello Rosa

8 July 2019  

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

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

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

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

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

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

By Brunello Rosa

1 July 2019  

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

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

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

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

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

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

But keeping all options open will also come at a huge economic cost. The option value of waiting for a resolution to US-China negotiations is leading many big businesses to a sort of “investment strike”, which is already weighing on economic performances in the largest, most advanced economies, such as the US, Germany and Japan. The ongoing balkanization of global supply chains will have an impact on companies’ cost structure irrespective of whether a trade deal will eventually be reached or not. As such, the real risk is that the damage that will be inflicted upon the US and world economy by this Cold War 2 and its various components (the trade war, technological competition, disruption of supply chains) is larger than is currently being estimated, and that a few cuts by proactive central banks will therefore not be able to prevent a global recession from occurring in 2020-21. 

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

By Brunello Rosa

24 June 2019  

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

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

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

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

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

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

By Brunello Rosa

17 June 2019  

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

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

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

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

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

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

by Brunello Rosa

13 May 2019  

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

ular, on Germany, in the auto sector. 

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

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

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

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

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

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

by Brunello Rosa

7 May 2019  

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

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

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

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

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

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

 by Brunello Rosa

29 April 2019  

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

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

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

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

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

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

by Brunello Rosa

23 April 2019  

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

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

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

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

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

by Brunello Rosa

18 March 2019  

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

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

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

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

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

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

by Brunello Rosa

11 March 2019  

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

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

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

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

by Brunello Rosa

4 March 2019  

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

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

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

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

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

by Brunello Rosa

25 February 2019  

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

Regarding US-China trade talks, Donald Trump said the US could extend the negotiations (perhaps by 30 or 60 days) from the March 1st deadline and meet with President Xi Jinping at Mar-a-Lago after the National People’s Congress on March 5th, given the progress made. Negotiators are preparing six Memorandums of Understanding (MoUs) on key structural issues such as: forced technology transfer and cyber theft; intellectual property rights; services; currency manipulation; agriculture; and non-tariff trade barriers. 

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

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

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

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

by Brunello Rosa

21 January 2019  

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

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

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

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

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

by Brunello Rosa

14 January 2019  

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

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

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

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

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

by Brunello Rosa

7 January 2019  

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

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

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

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

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

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

by Brunello Rosa

2 January 2019  

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

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

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

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

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

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

by Brunello Rosa

26 November 2018

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

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

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

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

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

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

by Brunello Rosa

19 November 2018

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

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

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

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

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

by Brunello Rosa

12 November 2018

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

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

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

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

by Brunello Rosa

5 November 2018

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

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

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

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

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