WEEKLY COLUMNS (ARCHIVE)

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by Brunello Rosa

15 April 2019  

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

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

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

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

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

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

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

 by Brunello Rosa

8 April 2019  

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

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

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

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

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

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

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

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

by Brunello Rosa

1 April 2019  

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

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

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

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

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

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

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

by Brunello Rosa

25 March 2019  

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

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

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

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

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

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

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

by Brunello Rosa

18 March 2019  

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

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

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

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

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

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

by Brunello Rosa

11 March 2019  

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

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

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

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

by Brunello Rosa

21 January 2019  

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

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

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

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

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

by Brunello Rosa

14 January 2019  

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

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

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

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

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

by Brunello Rosa

7 January 2019  

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

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

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

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

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

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

by Brunello Rosa

2 January 2019  

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

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

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

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

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

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

by Brunello Rosa

24 December 2018  

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

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

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

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

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

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

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

by Brunello Rosa

17 December 2018  

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

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

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

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

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

by Brunello Rosa

29 October 2018

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

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

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

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

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

by Bruello Rosa

22 October 2018

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

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

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

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

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

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

by Brunello Rosa

15 October 2018

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

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

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

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

by Brunello Rosa

8 October 2018

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

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

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

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

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

by Brunello Rosa

1 October 2018

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

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

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

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

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

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

by Brunello Rosa

24 September 2018

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

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

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

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

As discussed in our column on September 3rd, next week’s Tory party conference will be the last chance for the Conservatives to find a common position on Brexit negotiations. 

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

by Brunello Rosa

6 August 2018

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

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

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

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

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

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

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

by Brunello Rosa

30 July 2018

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

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

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

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

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

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

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

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

by Brunello Rosa

23 July 2018

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

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

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

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

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

by Brunello Rosa

16 July 2018

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

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

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

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

Read R&R Full Analysis Here

by Brunello Rosa

9 July 2018

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

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

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

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

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

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

by Brunello Rosa

2 July 2018

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

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

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

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

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

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