by Brunello Rosa
28 November 2022
At the end of October, the presidential election in Brazil saw the narrow victory of Luiz Inácio Lula da Silva over the incumbent president Jair Bolsonaro. In so many respects, Lula was considered to be the antithesis if Bolsonaro, but last week the news emerged that there may be an element of continuity between the two leaders. President Lula announced that although Brazil continues to condemn Russia’s invasion of Ukraine, it does not intend to apply the sanctions that the West has activated against Putin’s regime.
The reasons behind this choice are fundamentally economic, but possibly also geo-strategic. From an economic perspective, Russia and Brazil share cooperation in key sectors such as space and military technology, and telecommunication. For example, in 2012, after a state visit by Brazilian President Dilma Rousseff to Russia, Brazil signed an agreement to buy Russian anti-aircraft systems. At the same time, the state-owned Russian Technologies State Corporation (Rostec) and the Brazilian Odebrecht Defence and Technology signed a memorandum on technical cooperation, committing to the establishment of a joint venture for production of helicopters, air defence weapons, and naval vehicles.
Additionally, Brazil is of the main suppliers of commodities to China, including but not exclusively in agriculture, and China in turn has been one of the main allies of Russia during this period of Russia’s international isolation, since its invasion of Ukraine. In November, the Chinese authorities updated their list of approved Brazilian corn exporters, making it easier for Brazil to export its corn to China, at a time when China’s imports from the US and Ukraine have been disrupted by geopolitical tensions.
But, from a geo-strategic perspective, Brazil may be willing to follow the path of India. As discussed in depth in our recent report, India has so far decided not to choose between US and China in the dispute between the two economic superpowers that is now polarising the world. During the Cold War between the US and the Soviet Union, India tended to side with the Soviets.
But now Russia is on the same side as China, and tensions between China and India have increased recently, especially after the recent military exchange in the Himalayas. India is also part of the Quadrilateral security Dialogue (the Quad), together with the US, Japan and Australia, but at the same time is part of the BRICS gatherings together with China, Russia, Brazil, and South Africa, and it has recently struck favourable oil deals with Russia. So, India has resurrected his traditional non-aligned position, which it can afford given the size of its economy, and especially given the size of its population. During Cold War 1, India was one of the promoters of the so-called non-aligned movement, which was born after the Bandung Conference in 1955 and the Belgrade Conference of 1961.
Could Brazil do the same? Brazil certainly does not have the size of India’s economy (USD 1.6tn vs USD 3.1tn), nor India’s population (0.2bn vs 1.4bn). It is not part of a security dialogue like the Quad, and its ties with the US have been variable over time. At the same time it is part of BRICS meetings as India is, and it certainly wants to keep a good relationship with China and Russia. So, the far left-wing Lula will likely follow the path of far right-wing Bolsonaro in keeping Brazil out of the polarisation process that is dividing the world between the friends of China on the one hand and US allies on the other.
However, Brazil may not have the luxury to remain non-aligned for as long as India can afford. It may be forced to choose sooner rather than later. China will not want to lose its outpost in Latin America, but the US will not easily let go of the next largest country within its “backyard” of the Western hemisphere. As we discussed previously, like many other Latin American and African countries, Brazil may end up being a battlefield for a proxy conflict in this ongoing Cold War II between the US and China.
by Brunello Rosa
21 November 2022
Last week, the news emerged that the Republicans have finally conquered a slim majority in the House of Representatives at the mid-term elections. This came after the Democrats celebrated the fact that they retained control of the Senate, with at least 50 senators. If the Democrats win the run-off election in Georgia in early December, they may even increase their majority compared to the results they achieved in 2020. The youth and pro-abortion vote proved essential for the Democrats to win in many constituencies, in a polarised society in which yet another shooting (in this case against the LGBTQ community) took place last week.
The Republicans were hoping to get control of both branches of Congress to launch an impeachment process against Biden, his management of the Ukraine war and the relationships of his son Hunter in that country before the conflict exploded. Now they can try and pass the articles of impeachment in the House - that will already be hard enough, as some moderate Republicans will likely oppose it - but it will be almost impossible to win the battle for impeachment in the Democratic-controlled Senate.
The big question now is whether Joe Biden will run again for President in 2024. The “victory” in the mid-term election, as a red wave failed to materialise, would suggest he will, but he will make an official announcement only in January. Meanwhile, his competitor in the 2020 election Donald Trump has already announced that he will run again in 2024. Trump’s abrasive rhetoric, and the choice of “negationist” candidates who denied Biden’s victory in 2022 and then failed to win their seats in the mid-terms, was condemned by the Republicans as the reason for their defeat. So, he will again face an uphill battle to win the Republican nomination.
Trump’s candidacy will likely freeze most of the trials against him, for tax evasion, for his responsibility in the January 6th 2021 assault to Capitol Hill, and for having illegally collected secret documents from the White House when he moved out. An independent special prosecutor will need to be appointed to continue the investigations. The Democrat-led Department of Justice was very prudent in continuing the investigation, as it would be the first time in history that a former President is criminally investigated.
Now the paradox is that the Democrats seem willing to have Trump as their contender in 2024, as they consider him easier to beat. Whereas the Republicans would like to accelerate the trials, so that an indictment would prevent him from running for office and dividing the Republican camp once again. Meanwhile, Elon Musk, the new owner of Twitter, decided to re-open Trump’s profile, which had been banned in the aftermath of the assault on Capitol Hill, after a quick referendum with the users.
As usual, US domestic politics has international ramifications. In particular, the Russian army decided to withdraw from Kherson and all territories west of the Dnieper river as soon as they realised that Biden will not become a lame duck. If Trump had become the most likely successor to Biden, the Russian calculus regarding the war in Ukraine would have probably changed.
In the next couple of years, US domestic politics will return centre stage with the primary election for the presidential election of November 2024. We will continue to follow that closely, given their international implications.
by Brunello Rosa
14 November 2022
The news of the last few days seems to suggest that a bubble is bursting in the tech sector. After completing a USD 44bn acquisition of Twitter, the new owner and boss Elon Musk fired half of the company's workforce in an attempt to increase efficiency and restore profitability. A few days later, Mark Zuckerberg, the head of Meta, fired 11,000 Facebook employeeswith a simple email. During the same few days FTX, one of the major crypto exchanges, collapsed, after its arch-rival Binance pulled out of a possible attempt to rescue its competitor. All this happens as Nasdaq (the equity index specialised in tech) has been severely underperforming its more general counterpartssince the beginning of the year: Nasdaq is down 28% y-t-d, while the S&P is down 16% and the Dow Jones 7%.
Given this background, it has been quite obvious to ask whether a bubble has burst in the tech sector. Our view is that the reports of the tech sector’s death are being greatly exaggerated, for a series of reasons.
First of all, the recent fall in tech valuations has followed a period of massive out-performance, coinciding with the pandemic, when widespread lockdowns implied a massive use of technologies to satisfy even the most basic needs, such as the purchase of groceries. So a post-pandemic adjustment seemed inevitable. Clearly this adjustment is adding to the re-evaluation of general indices, leading to the above-mentioned underperformance.
Secondly, this is not the first time the sector has undergone a major re-alignment of market valuations with economic fundamentals.
The dot-com bubble burst in 2000 wiped out a large chunk of the value of the tech companies at that time, but also represented the opportunity to identify those companies that really deserved to survive. Some of them, such as Amazon, and the like, are the champions of today’s tech scene and are among the largest companies in the world by market capitalisation. As we are moving toward the so-called Web 3, it is only healthy that the champions of Web 2undergo a reality check.
Thirdly, a new wave of technological innovation is about to come online, from fin-tech, to med-tech, bio-tech, and so on. For example in the financial domain, central banks are about the enter cyber-space with central bank digital currencies(CBDCs), and cyberwarfare is now a standard companion of traditional war methodologies. This will require plenty of investment in “digital infrastructure” (servers, cables, mainframes, etc.), which will likely boost tech valuations as soon as this bear market ends.
So, if the current episode does not represent the bursting of a tech bubble, how can we explain it? We believe that the current episode can be explained by two theories. First of all, as Hyman Minsky’s financial instability hypothesis suggests, when central banks increase interest rates, the most fragile, speculative positions tend to fail, thus determining the equity market re-pricing that we are observing in this period. Additionally, the sector is undergoing the process of creative destruction described by Joseph Schumpeteras one of the key drivers of capitalism. After this clean-up, the tech sector will be ready to re-start even stronger than before.
by Brunello Rosa
7 November 2022
Last week, the October-November round of major central bank meetings came to an end. As discussed in our previews and reviews, the Federal Reserve increased its policy target range by 75bps, as had widely been expected. Market participants were exposed to mixed signals from the Fed. On the one hand, the Fed reassured them that, in December, a discussion would start within the FOMC regarding whether and when to reduce the pace of tightening, taking into account the cumulative actions that have been taken since March 2022. On the other hand, the FOMC statement suggested that the terminal rate would be higher than previously had been expected by market participants. The market reacted with a see-saw price action, with a net effect of there being losses in equity and bond prices.
The Bank of England also had to provide mixed signals to the market, while increasing the Bank Rate by 75bps as well. It re-started QT and promised more rate hikes, but also said that the terminal rate would be lower than currently expected by the market. Again, market prices were volatile following the release of news by the central bank.
These are only two examples of how policy news has been buffeting financial markets in the last few months. More specifically, the UK staged an example of how monetary and fiscal policy may end up on a collision course, with the result of causing a financial market rout, around the time of the Truss-Kwarteng mini-budget and the LDI debacle.
But there is a more subtle inconsistency within monetary policy itself that is causing trouble for central bankers all around the world, namely the potential conflict between price stability and financial stability.
Virtually all central banks around the world, perhaps with the exception of the Bank of Japan, are fighting inflation to restore price stability, with a combination of higher policy rates, balance sheet policies (such as Quantitative Tightening) and to a certain extent forward guidance (provided by the forecasts of terminal policy rates, for example).
At the same time, rising rates and tightening financial conditions risk causing financial instability episodes, which would force central banks to stop their policy normalisation cycles, or even to stop their tightening cycles. In a sort of unofficial way, most central banks are now heading towards a division of labour between interest rates (devoted to price stability) and balance sheet policies (aimed at financial stability). The ECB offers the perfect example of this: while increasing interest rates, the ECB continues to provide a backstop to the eurozone bond market by re-investing the proceeds of maturing bonds in full. And even when the ECB does start its QT program, the TPI facility will ensure that bonds can be selectively purchased in order to avoid financial instability episodes emerging.
The Federal Reserve has recently formalised this trade-off between price stability and financial stability with the introduction of a new theoretical framework. In this framework, a new rate (called r**, the rate above which a financial instability episode may be triggered) is defined besides the traditional r* (the rate at which monetary policy is neither stimulating nor restricting economic growth). If r** is lower than r*, the central banks will need to stop its pursuit of price stability sooner than its desired neutral level, in order to avoid financial instability. But even if r** is above r*, the central bank may need to stop its tightening cycle, if its desired terminal rate is above the neutral rate.
These examples show how policy inconsistencies are here to stay, and that they will continue to determine market dynamics in coming months.
by Brunello Rosa
31 October 2022
Last week, Ukrainian forces struck the Russian fleet in the Bleak Sea with a massive drone attack in Sevastopol. The Russians are accusing the British army and intelligence services of having contributed to the planning of the attack. They have retaliated by suspending the agreement on grains, which allowed Ukrainian crops to be distributed globally. So, tensions are clearly on the rise in the Russian-Ukraine war, and the risk of a further escalation exists.
Recently Russian President Putin said that the use of nuclear weapons is not necessary in the war in Ukraine, and that Russia is now ready to negotiate. To which US President Biden responded that his Russian counterpart is only posturing. In effect, Russian foreign minister Sergej Lavrov recently repeated what he had already said already in April 2022, namely that the current situation is as severe as the Cuban missile crisis of 1962, when the US and the Soviet Union got closest to a possible nuclear exchange during the entire Cold War.
The real question therefore is how close we are to a potential nuclear conflict in Ukraine, and which countries such a conflict would involve. The answer to this question is quite disturbing, in the sense that of course nobody can predict with any degree of certainty how close we really are to an actual nuclear attack. By definition of using nuclear bombs as a deterrent, one country needs to use the threat to the fullest possible extent to extract as many concessions as possible from its rival, even if the nuclear weapon is never actually deployed.
At the same time, the impression is that we may not be very far from an exchange that will include nuclear weapons. In particular, the more the Ukrainian army regains control of the provinces that were illegally annexed by Russia in recent weeks (especially in Kherson), the more likely it becomes that Putin will see no alternative other than using a nuclear device to defend the “territorial integrity of Russia.” This was the main motivation for Russia’s speeding up the annexation process of the four provinces.
The Russians are accusing the Ukrainians of wanting to prepare the use of a “dirty” bomb, i.e. a conventional bomb with some nuclear component (e.g. uranium from nuclear power plants). If that were to happen, this would certainly constitute a pretext for the Russians to use their “tactical” nuclear devices. As discussed in our previous column, these tactical devices would serve a double purpose. First, they would be intended to annihilate the morale of the Ukrainian army. Second, they would potentially inflict an irreparable wound to the continuity of the Ukrainian government.
How would the West then react? The US and NATO are not officially involved in the conflict, and certainly they are not directly involved, even though it is clear to all that the most recent advancements by the Ukrainian forces have been possible only because of the military technology provided by NATO, and especially by the US and the UK. Hence, the US cannot directly react with another nuclear strike: doing so would be the beginning of an escalation that would quickly bring to the beginning of World War III, and the end of the world as we currently know it.
So, the Americans may stage a brutal reaction which may involve weapons that may not be fully known to the Russians, or to other NATO allies, weapons that could be deployed as a one-off response to end the conflict with Russia, bringing it to a sort of perennial standstill. The questions within US policy circles are: should they keep these cards close to the chest, so to maximise the surprise effect if and when Putin has launched its nuclear attack? Or should they publicise to the fullest extent what reaction they are ready to stage in case of a Russian nuclear attack, so as to dissuade Putin from launching it in the first place?
A shared line has not yet emerged, but rather a sort of mixed approach, with former CIA director and US general David Petraeus saying that the US would wipe out all Russian forces in Ukraine in case of a Russian nuclear attack, but without specifying how and over what time horizon doing so would be accomplished. Our hope is that Putin may in fact be dissuaded from launching a tactical nuclear attack by knowing that the US reaction would be ferocious. But our hope does not necessarily coincide entirely with our expectation.
by Brunello Rosa
24 October 2022
Last week, the drama surrounding the British government came to a sudden conclusion. After sacking her finance minister Kwasi Kwarteng in an extreme attempt to save her job, Prime Minister Liz Truss had to give in and hand her resignation in as head of the Conservative party, less than two months after winning its leadership contest. As with Boris Johnson before her, she will remain as Prime Minister until a successor is found, ideally by the end of this week.
The hope by the conservative leaders is that, if there are multiple candidates vying to replace Truss, one of the last two remaining candidates will withdraw from the race in order to avoid the choice being left to the base membership of the party, which would imply a longer process. At one point it seemed that Boris Johnson would enter the race in an attempt at staging an unexpected comeback, just a few months after leaving his position as Tory leader, but then he withdrew from the competition. At this stage, Rishi Sunak is the frontrunner of the competition.
What led to this sudden conclusion? First, Liz Truss replaced Kwasi Kwarteng with Jeremy Hunt, who is perceived to be a much safer pair of hands than Kwarteng was. From that position, Hunt performed a U-turn on the fiscal policies introduced by Truss and Kwarteng in the so-called mini-budget presented earlier in October, which we labelled as an “economic gamble.” Instead of promising GBP 45bn of unfunded tax cuts, Hunt presented a plan of GBP 41bn of spending cuts. With these moves, Hunt appeared to be the de-facto Prime Minister, overshadowing Truss and her flagship economic program.
Second, Truss’s attempts at manoeuvring within the UK political scene proved to be totally ineffective vis-à-vis the market reaction to her economic plans. The market continued to be sceptical of her plans, and of what may have been presented in the actual budget. As a result, the GBP continued to be under the cosh, reaching almost parity with the USD. Long-term rates also continued to face upward pressure, especially after the Bank of England stopped its emergency bond-purchases program.
The third factor behind the conclusion of these political events was the conflict between price stability and financial stability that caught fiscal policy in the middle (even if fiscal policy ended up being the trigger for the financial stability episode). In the UK, like in any other major country, central banks are focused on fighting rampant post-pandemic inflation by increasing rates frequently and in large step. By doing so, they risk triggering financial stability episodes in a fragile system, as the Financial Instability Hypothesis by Hyman Minsky would suggest.
In this case, the episode was triggered by reckless fiscal plans that led to an increase in interest rates in the leveraged system of pension funds performing LDIs. When these funds received margin calls to cover their derivatives position, they had to sell the most liquid assets, i.e. gilts, to get the cash they needed, thus triggering a further increase in rates, until the BoE stepped in to save the day.
The clear lesson of this entire saga is that market discipline still works, and that even those countries that pride themselves of being financially advanced, such as the UK, are subject to it. This is good news, because the market will induce governments to adopt sounder fiscal policies, at a time when they may be the only source of support to dwindling economic activity, which is at risk of soon entering a recession.
by Brunello Rosa
17 October 2022
The annual IMF meetings took place last week, and they were held in an in-person format for the first time in three years. At the centre of attention in these meetings there were of course the geopolitical developments that – as we discussed in our latest column – are having such a large impact on key macroeconomic variables, such as GDP and inflation, as well as on financial markets.
As usual, the IMF released its updated World Economic Outlook, titled “Countering The Cost-Of-Living Crisis”. It foresaw a revision of the key macroeconomic variables consistent with a stagflationary shock: an upward revision in the inflation profile and a downward revision in the growth outlook. Global growth is now forecast to be 3.2% in 2022 and 2.7% in 2023, compared to the 3.2% and 2.9% expected in July 2022.
Another element that was clearly present at the IMF meeting was the sense of policy uncertainty that is prevailing among policymakers. In March this year, in our article titled “Is There An Optimal Policy Mix To Get The Global Economy Out Of The Current Difficult Conjuncture?” we discussed how it is very hard to reach all policy goals that policymakers are setting for themselves (i.e., higher growth, lower inflation, low long-term interest rates and to severely punish Russia for its illegal invasion of Ukraine) with the instruments at their disposal, namely monetary and fiscal policy and sanctions. In particular, we noted how monetary policy and fiscal policy risked entering into a conflict with one another: fiscal easing would be inflationary whereas monetary tightening would depress economic activity.
Our conclusion was that policymakers would only have two solutions: either a) give up at least one of their goals, to focus instead on the others; or b) give up a bit of all goals, and achieve a sub-optimal result on all fronts. In all cases, in these circumstances policymakers cannot aim at finding an optimal policy mix, bur rather can only minimize the effects of the inevitable policy errors that they will make.
In the last few weeks, the UK provided a live case of the point we made: reckless fiscal policy (what we called a “gamble” in our column), uncoordinated with monetary policy or even with the forecasts of the Office for Budget Responsibility, led to a collapse in the value of GBP, and a spike in long-term rates that risked bankrupting the private pension system (undertaking LDIs – Liability Driven Investment). The Bank of England had to step in to bail-out the pension system by committing to re-open asset purchases for the sake of financial stability rather than price stability. Events unfolded further, with Liz Truss forced to sack the Chancellor Kwasi Kwarteng and replace himwith the much safer Jeremy Hunt.
The UK case made clear what had already started to become visible on the horizon: central banks can increase short-term interest rates to fight inflation and also buy long-term government bonds to ensure the financial stability of the smooth transition of monetary policy (e.g. the ECB’s TPI). This seemed unconceivable until a few months ago, as it would have represented a policy inconsistency within monetary policy, given the mixed signals that this would send to market participants.
But in this word of policy uncertainty and absence of an optimal policy mix, we need to get used to policy inconsistencies, policy mistakes and even conflicts between the various areas of policymaking.
by Brunello Rosa
10 October 2022
This past week has been another very eventful one, from a geopolitical perspective. First, besides the ongoing cyberwarfare between the two sides, which we discussed in our recent analysis, the threat of a possible nuclear escalation in the Russia-Ukraine conflict has become even more vivid. Initially, Russian President Vladimir Putin promoted referenda in four Ukrainian provinces which he claims are under control of the Russian army: Donetsk, Luhansk, Kherson and Zaporizhzhia. Then he ratified the results in favour of the annexation of these provinces, which the international community is not recognizing.
This was the crucial step to saying that any attack on those regions would imply a direct attack on Russia. According to the Russian doctrine for the use of nuclear weapon, any threat to the security of the Russian territory - not necessarily an actual attack, but rather any threat considered “imminent” - would justify the use of the nuclear arsenal.
There is a lot of talk about the use of “tactical” nuclear weapons, which have a smaller radius of action. Commentators and the wider public opinion are even starting to consider the use of those weapons similar to that of conventional artillery. But they are not. Their use would still represent the beginning of a nuclear holocaust, not too dissimilar to what happened in the Japanese cities of Hiroshima and Nagasaki at the end of WWII. Hiroshima and Nagasaki have been in fact quoted many times by the Russian government in their rhetoric, to justify the use of Russia’s nuclear arsenal. This is the reason why US President Biden spoke about a potential Armageddon that would derive from such a possible move from the Russians.
We need to hope that the nuclear escalation does not progress further, as it is unclear how it would end. The bombing of the Kerch bridge that connects the Russian mainland to Crimea meanwhile might represent another starting point for further escalation, which is the reason now nobody wants to claim to be the author of that attack.
Also taking place this past week, the OPEC+ cartel decided to cut oil production by around 2m barrels a day, in order to support falling oil prices and keep the price close to 100$pb. The move clearly benefits Russia at this difficult juncture in its war with Ukraine, and it could have never been adopted without the decisive input of Saudi Arabia, the major stakeholder of OPEC.
This confirms what we discussed in our column of a few weeks ago: the emergence of a new bloc of countries, established around the BRICS gathering and now including Saudi Arabia as well and that is in direct competition with the G7, which is centred around the US. In one of our recent papers, we discussed how Saudi Arabia was re-gaining centre stage in the more multipolar world that is currently emerging.
This is the reason why both President Biden and US Treasury Secretary Yellen complained about the cut to oil production inspired by Saudi Arabia, which risks tipping the global economy into a recession. And all this while the EU struggles to find a unified position around the proposal of a price cap for oil and gas imports from Russia.
These are just some of the examples that show that geopolitics remains at the centre stage in world affairs, and is one of the main determinants of key macro-financial variables, including oil prices (a crucial input for headline inflation) and GDP.
by Brunello Rosa
3 October 2022
Last week the UK went through one of the most dramatic periods of its recent history. The events started with the not so-mini-budget that was presented on Friday, September 23rdby the Chancellor of the Exchequer Kwasi Kwarteng, which we discussed at length in our previous column and subsequent podcast.
As we argued in our column, the fiscal measures introduced by the Chancellor represent an economic gamble, as they consist of unfunded tax cuts worth GBP 45bn, to be added to the roughly GBP 100bn of measures that were adopted to cushion the effects of the energy crisis on households and companies. This would imply an additional GBP 150bn of borrowing by the government; i.e. gilts to be issued by the Treasury and presumably absorbed by the market. All this, without any forecast on economic growth and related fiscal deficit projections by the Office for Budget Responsibility (OBR), which generally accompany the issuance of the budget.
The results of these decisions have been disastrous. Investors have started to ask for higher yields to absorb the upcoming extra borrowing planned by the UK Treasury. Pension funds have been caught in margin calls, which forced them to sell even more gilts to get hold of cash to close these margins. This has made the price of gilts collapse and their yields rise rapidly. To stop this vicious circle, the Bank of England had to step in and launch an emergency program of GBP 65bn of purchases of gilts to be carried out over the following fortnight. Meanwhile, the GBP collapsed to its lowest level in recent history. Tory MPs threatened a no-confidence vote on Truss just weeks after having chosen her as their new party leader. Truss and Kwarteng had to meet with the OBR in order to inject confidence into the market, even though the meeting did not end with any sign of a policy U-turn by the government.
The question we are asking ourselves is the following: is there any lesson that Giorgia Meloni, likely to be appointed PM in Italy, may learn from Liz Truss? After all, Liz Truss, in spite of all her shortcomings in communicating her policy intentions to the public, is an experienced politician and member of government, who studied Philosophy, Politics and Economics, the famous PPE course of the University of Oxford attended by many prime ministers before her. And Kwasi Kwarteng, after studying at Eton, has obtained various degrees, including a PhD at Cambridge University. In spite of these prestigious pedigrees, they made a mess of their first few days at the helm of the government.
Giorgia Meloni and her closest aids lack the academic background of her UK counterparts, so she may seemingly be starting at a disadvantage. Yet she may be able to learn a few lessons from what happened to Truss and so avoid making the same mistakes. The first lesson to learn is that being a person of conviction only buys you some time and credibility: it is the test with reality that makes the difference, especially if one is extremely convinced about the wrong ideas. The second lesson is to always be surrounded by the best people you can find, not just by acolytes and minions. Finally, never challenge the markets if you have a large amount of debt to refinance. You may end up needing to ask for the intervention of the central bank. In the case of Italy, this is now mediated by the eligibility for TPI, which is subject to a high degree of discretion by the ECB.
As we said in our preview, we do not expect Giorgia Meloni to start her period of PM with bellicose intentions. However, as Liz Truss shows, a couple of wrong moves may transform the honeymoon phase into a debacle. Giorgia Meloni may end up being on a collision course with the markets and European authorities before show knows it.
by Brunello Rosa
26 September 2022
Last week was an eventful one. On Wednesday, the US Federal Reserve increased its policy target range by additional 75bps, to 3-3.25%. On Thursday, the Bank of England increased its policy rate by 50bps to 2.25% in order to tackle rampant inflation. And on Sunday general elections were held in Italy. Russian President Vladimir Putin meanwhile announced the partial mobilisation of Russians of fighting age, which most commentators interpreted as an escalation of the war.
While these events were taking place, on Friday the new UK Chancellor of the Exchequer, Kwasi Kwarteng announced its Growth Plan for the UK, which, according to its proponents, represents the “biggest package of tax cuts in generations.” The fiscal package, which is larger than a regular budget, will be comprised the following measures:
For households, a) the basic rate of income tax will be cut to 19% in April 2023, one year earlier than planned; b) the 45% additional rate of income tax will be abolished; and c) there will be changes made to the Stamp Duty regime for homebuyers, with 200,000 people expected not to pay the tax altogether each year. This comes a day after the government announced that the Health and Social Care Levy (HSCL) of 1.25%, due to be introduced from April 2023, will not be implemented, and that the 1.25% increase in National Insurance contributions (NICs) rates that was introduced in April 2022 will end on 6 November 2022.
For companies there are planned tax cuts as well, in particular: a) the cancellation of the planned increase to the Corporation Tax (CT) main rate from 19% to 25%, with changes made to the dividend tax rate; b) the cancellation of the planned increase in the rate of Diverted Profits Tax from 25% to 31%, and the planned reduction in the Corporate Tax surcharge rate for banking companies, both of which are expected to take effect from 1 April 2023; and c) the introduction of new investment zones around the UK where enhanced tax reliefs will be offered for Stamp Duty Land Tax (SDLT), Enhanced Capital Allowances, Structures and Buildings Allowance and Employer National Insurance contributions.
The government expects these tax cuts to increase the UK’s growth potential from 1.75% to 2.5%, and to increase productivity and wages over time. Considering as well the measures that were introduced in previous weeks, in particular the Energy Price Guarantee that was made in response to the large increases in gas prices that are being experienced by households and companies, how credible are these promises?
The Bank of England, in its latest statement, said that it will assess the overall impact of these measures on growth and inflation, and their implications for monetary policy, in the November 2022 Monetary Policy Report. In its preliminary assessment the BoE announced that by increasing disposable income the energy price cap may induce stronger spending, which could be inflationary.
Therein lies the real risk, which we discussed in previous analysis. Monetary policy and fiscal policy are not working in the same direction anymore. To the contrary: fiscal easing to support economic activity tends to be inflationary, whereas monetary tightening to combat inflation tends to be recessionary. The monetary-fiscal coordination that worked so well during the pandemic is now a distant memory. And the biggest problem is that an optimal policy mix does not even exist.
The UK government does not seem to have understood this point. It has introduced a massive plan of tax cuts as it was operating in isolation, without considering the potential inflationary impact, at the same time as the BoE is trying to tame inflation with higher rates and QT. Moreover, these tax cuts imply much larger borrowing, which may also result in higher long-term rates, which in turn tend to depress economic activity.
Markets have been fast to provide their response, with the GBP sinking versus the USD to one of its lowest points on record. Voters in the UK seem to have expressed their view as well, with polls showing a solid Labour lead (42% versus 33%, with LibDems, SNP and Greens – all potential allies of Labour – polling at 20% collectively). Liz Truss should learn from Margaret Thatcher, whom she considers to be her role model. Thatcher did increase taxes, including the hated VAT, before cutting taxes. And her government collapsed on the proposed introduction of the poll tax, intended to finance local governments.
by Brunello Rosa
19 September 2022
Italy will hold a general election this Sunday, to elect its 19th parliament since the return of democracy in 1948. This will be an early election, called after the resignation of Mario Draghi in July following the de-facto loss of confidence by parliament in Draghi’s government. The no-confidence process was started by M5S’s leader Giuseppe Conte, but ultimately it was Berlusconi’s Forza Italia and Salvini’s Lega that pulled the plug, leaving only Enrico Letta’s PD to support the government.
This election will be peculiar mainly for two reasons. Institutionally, following the 2020 constitutional referendum, the number of MPs has been drastically reduced, from 630 to 400 Deputies for the Chamber, and from 315 to 200 Senators for the Senate. This also has a political implication, since the constituencies have also been re-designed, with more weight now being given to peripheral areas and suburbs, and less to city centres where the centre-left is traditionally stronger.
Politically, the general election is widely expected to result in a landslide victory by the centre-right, led by Giorgia Meloni of the Fratelli D’Italia (FdI). This is due to the fact that FdI was the only party officially in opposition to Draghi’s government in parliament. After the fall of Draghi’s government, she therefore emerged as the only credible alternative to the status quo. Also, the decision by centre-left parties (the PD, the M5S and the so-called Terzo Polo of Azione + Italia Viva, both of which splintered from the PD during this parliament) not to run in a coalition will likely allow the centre-right to win all the first-past-the-post seats, which are around 1/3 of the total number of seats (the rest are elected with a proportional representation system), likely leading to a massive defeat.
On the other side of the political spectrum, FdI is likely to be by far the most voted for party in the centre-right coalition, which should imply that Meloni becomes the most obvious candidate to become Italy’s next prime minister. Things may change depending on the overall electoral results, and, in particular, on the results within the centre-right, and the distance between the first and second party in their coalition.
The latest available poll shows that FdI is at 25.3% of voting intentions, PD at 23.3%, Lega at 12.3%, M5S (12%), Forza Italia 6.7%, Azione + Italia Viva 6.4%, and the Greens and Left together 4.1%. If the eventual outcome of the election is similar to these polls, with FdI having a number of MPs almost double than that of its immediate follower, Lega, then Meloni can legitimately claim to become Italy’s next PM.
What would a Meloni government do? In our opinion, there are two scenarios to consider here. If the centre-right wins enough votes to be able to change the Constitution without requiring a confirmative referendum – it will need a two-thirds majority in each chamber of parliament in order to do so – then we believe the centre-right coalition will devote most of its energy to changing the Constitution towards a presidential or semi-presidential system in which the head of state is elected directly by the people.
If instead the centre-right wins “only” a simple majority, it will devote most of its energy on the economic front. It will likely review the recovery plan (PNRR) and pursue a tax reform to introduce elements of a flat tax.
In any case, markets seem relatively relaxed at this stage, in spite of Italy’s large debt/GDP ratio. Partly this is because growth has lately surprised on the upside, and the fiscal deficit on the downside. But things may change rapidly if Meloni, unwisely, decides to set Italy on a collision course with the EU on economic or rule-of-law themes.
by Brunello Rosa
12 September 2022
Last week, Elizabeth II, Queen of the United Kingdom and other Commonwealth realms, died at the age of 96. Her kingdom lasted 70 years, making her the longest-serving monarch in British history. Only months ago the country celebrated the platinum jubilee of her accession to the throne, which took place on 6 February 1952, when she was just 25 years old. During her life, Queen Elizabeth has appointed 15 prime ministers, the first one being Winston Churchill, the last being Liz Truss.
The world has changed around her during her time as Queen. The first US President she met was Harry Truman, who succeeded Franklin D. Roosevelt; the last one was Joe Biden. In between these, she met with diverse characters such as John F. Kennedy, Richard Nixon, and Barack Obama. The UK has gone through tragedies and humiliations such as the Suez Crisis in 1956, and triumphs such as the Falklands war in 1982. During her kingdom, the UK entered the EU (in 1973) and later exited it (2020), and London has become the world’s foremost financial centre.
Overall, during this long span of time, the UK has certainly increased its influence and prestige at the global level. Domestically, the UK has gone through difficult periods, such as the troubles in Northern Ireland, which ended only in 1997 with the Good Friday agreement. In 2014, the UK survived an independence referendum by Scotland. So, one can say that, during the second Elizabethan era, the UK has strengthened domestically and on the global stage. Elizabeth leaves a heavy legacy for her successors in this regard.
King Charles III will have to begin from where his mother left. His name is a difficult one. Charles I was the first king executed in European modern history (in 1649, more than a century before the French Revolution). Charles II was forced to live in exile during the rule of Oliver Cromwell as Lord Protector of the UK, and was able to return only at the death of the dictator. Charles III will be confronted with phenomenal secession pressures, from Northern Ireland and from Scotland.
As we discussed in our previous column, the victory of the Sinn Fein on the two sides of the isle of Ireland makes a re-unification referendum for the island more likely. On that occasion we said that such a referendum would not take place while the Queen was alive. But now the clock is ticking, and it will take some serious effort by Charles to convince Northern Ireland that they are better off inside the UK rather than within the EU. This task will become even harder, as Liz Truss has declared her intention to re-discuss the Northern Ireland protocol with the EU. Meanwhile, regarding Scotland, First Minister Nicola Sturgeon has also said that it intends to launch a new independence referendum by 2023. Anow that the UK is out of the EU, pro-European Scotland may opt for the independence route.
Domestically, Charles will likely oversee an autumn and winter of severe discontent among the UK population, given the cost-of-living crisis originating from the rise in energy prices.
For all these reasons, a very steady hand will be needed to keep the country together and drive it out of this current difficult situation. This is the reason why Charles has immediately appointed his son William as Prince of Wales, making him a de-facto right hand to the throne, in the hope that this “duumvirate” will help Britain navigate the new few difficult years.
by Brunello Rosa
5 September 2022
At the and the end of last week, the figures for US Non-Farm Payrolls (NFP) were released. The US Bureau of Labour Statistics reported that the US economy added 315K jobs in August of 2022, compared to a downwardly revised 526K in July (p. 528), but above market expectation of 300K and pointing to broad-based hiring across many sectors. Even if the unemployment rate rose slightly from 3.5% to 3.7%, non-farm employment is now 240K higher than its pre-pandemic level in February 2020.
On the basis of these figures, even if employment figures are a lagging indicator of economic activity, it may be correct to say that the US economy is not in a recession, not even a technical one, in spite of two consecutive quarters of contraction. This seems to be confirmed by a cross-check through the lense of the so-called Okun’s law, which links unemployment and GDP changes. According to a recent analysis, the US economy may have actually been growing in H1. This is crucial in determining what the Fed, and other major central banks, will do in coming months.
Regarding the Fed, at its traditional gathering in Jackson Hole Chair Powell surprised the market with unexpectedly hawkish remarks. Powell said that the US economy remains strong and the world economy resilient in the face of the ongoing energy crisis deriving from the war in Ukraine, and therefore the FOMC will continue tightening its policy stance. The FOMC will continue aiming for a “soft landing” of the economy, but the Committee priority is now to bring inflation (which is still running at 8.5% y/y) back to target. Commentators and markets read this as an anticipation that another 75bps rate increase will be delivered in September. In July, Powell clarified that the Fed will not provide as much forward guidance as before, as the FOMC has become data dependent, but this seems now a reasonable assumption.
But more than the decisions that the Fed makes in any given meeting, what matters is the cumulative amount of tightening that takes place. In this respect, the Fed has recently reached neutral territory with its policy rate (2.50%), and it is ready to enter restrictive territory with the next rate increase, to reach and overcome the 3-3.25% expected at year-end according to its SEP dots. However, one should note that with inflation at 8.5% and a policy rate at even 3.5%, policy rates would still be negative in real terms, meaning that in real terms the Fed’s policy stance remains highly accommodative. To bring inflation down to 2%, much more tightening may be needed.
Regarding the ECB, next week another 50bps rate increase is expected, but perhaps a surprise 75bps hike cannot be ruled out. This follows the remarks by ECB Board Member Isabel Schnabel, who said that the ECB may need to make further “sacrifices” (i.e. rate increases) as the inflation outlook has not improved. Additionally, the ECB’s policy stance cannot remain too distant from that of the Fed, at a time when the EUR has already fallen below parity versus the USD. A weaker currency contributes to higher inflation rates, at a time when the ECB is trying to bring inflation back to target.
by Brunello Rosa
29 August 2022
A few weeks ago, after Boris Johnson resigned as UK Prime Minister, we published a column titled “Johnson’s Resignation Opens The Gate To A Real Post-Brexit Britain.” In that column we discussed the possible contenders for the leadership race, indicating Rishi Sunak and Liz Truss as the clear frontrunners. We also warned that, once that Brexit was “done” by Boris Johnson, the new Tory party leader and future PM will have to deliver on what Brexit will really mean for the country; in particular, by showing what benefits it could derive from leaving the EU.
This week, the leadership race will come to an end, with the election of Johnson’s successor by 161,000 Tory party members on September 5th. Liz Truss is widely expected to win the race. Sunak has been one of the most popular ministers in Johnson’s cabinet, widely praised for his sensible approach to the pandemic, which was epitomised in the furlough scheme that was launched to make sure that millions of people did not lose their jobs. But Truss has been a party member far longer than Sunak, and she is clearly favoured by the party grandees, as well as by the base. She comes from the party ranks, and can probably speak to the belly of the country better than Sunak can.
In spite of the humble origins of his family, Sunak would seem an elitist choice, considering his business studies at Stanford and his marriage with the daughter of one of the richest men in India. The fact that his wife was caught using a legal scheme to pay less taxes in the UK did not help. Sunak would speak to Britain’s minds. But in a period in which populism is still in vogue, speaking to the belly of the country goes a longer way than speaking to the mind. This is the reason Liz Truss will likely win the race.
We have already discussed the differences in policies between Sunak and Truss; a further comparison between the two can be found here. But there is an aspect of the difference between them that it is worth discussing in greater depth. Let us assume that Liz Truss wins the race. She is considered to be a die-hard Brexiter, with a level of zealotry that only “the converted” have (she voted to remain in the EU in 2016).
Truss reportedly wants to transform the UK in a sort of Singapore-on-Thames, with a super low tax rate. Hence, her proposal of reducing taxes by GBP 30bn from “day one” in office. She also wants to reduce the regulatory burden, to take advantage of the divergence in standards with the EU that the UK has gained from Brexit. She also wants to revisit the Northern Ireland protocol, which regulates the relationship between UK and the rest of the EU at the Irish border. In terms of economic policy, she is clearly in favour of tax cuts over “cash handouts.” But even Margaret Thatcher increased taxes (for example VAT), before announcing tax cuts, years later.
Some commentators say that “Liz Truss can do a lot of damage before she’s thrown out, as she will be, in 2024.” Others believe that, “If she wins, and enacts her promise of immediate tax cuts, the only safe prediction is that sterling will crash.” While we are somewhat concerned by her proposed policy, we believe that Truss is likely to show to the UK what Brexit really means, in both a positive and a negative sense.
by Brunello Rosa
22 August 2022
Since mid-June 2022, the S&P 500 equity index has risen more than 15%, reaching 4228 points at the end of last week. This rally has helped the index (and similar indices around the globe) exit bear market territory, defined as a fall in equity prices of at least 20% from its recent peak, which it entered in June just before this rally begun.
The index is still down 11% year-to-date, but only 5% from one year ago. It is actually up 45% over the last three years, and an astonishing 500% since March 2009, when the post-Global Financial Crisis (GFC) rally begun. The index has been one of the major beneficiaries of the massive liquidity injections made by central banks around the world in the last 14 years, with various round of QE to combat the various shocks the global economy underwent in the period, and in particular the GFC and the Covid-19 pandemic.
This introductory background serves the purpose of providing some context for one of the hottest debates among market participants in this period; namely, will this mid-summer market rally last, at least until the autumn, and possibly beyond? As we know, market participants tend to have a short-term horizon for their decisions. But putting things into context here may help to provide an answer.
We discussed recently about the asynchronous nature of financial and business cycles, with financial cycles typically anticipating the developments of the real economy. In this context, we warned that we could see markets rallying when the economy was entering a recession, having fallen in advance, before the economic cycle turned downward. In this case, the key indicators that markets are watching are inflation data and the response of central banks. If inflation starts showing signs of peaking and central banks signal that they can stop their tightening cycle soon, markets would be ready to rally.
This is what has fuelled the mid-summer rally so far. Inflation has shown some (mixed) signals of peaking, and the Fed, at its July FOMC meetings, said that it is now data dependent, and not on a pre-set course of action.
What about the future? The real economy shows further signs of deceleration globally, starting in China and Europe, and a contraction in economic activity taking place at the end of this year cannot be ruled out. The US has already exhibited two consecutive quarters of negative growth meanwhile, but various one-off factors seem to convince policymakers that this still does not represent even a technical recession.
On the other hand, labour markets remain tight, on both sides of the Atlantic. And with unemployment rates still at historical lows, wage growth remains strong, pushing up domestically generated inflation. In the UK, for example, inflation has surprised on the upside again, and market participants now expect another 50bps rate increase in September by the Bank of England.
Central banks will not stop increasing rates until they are sure that inflation is tamed, even if this implies a strong deceleration, and potentially even a contraction in economic activity (to some extent, this is in fact what central banks are trying to engineer). Central banks, which have a longer time horizon than market participants, know that markets can suffer some additional losses (precisely because some equity indices have rallied 500% since the QE experiment began), if such losses are the price needed to pay for reining in inflation. So, the mid-summer rally may come to an abrupt halt when central bank activity resumes in September.
The real puzzling piece in this jigsaw is the following: if a debt crisis accompanies the upcoming economic downturn, the reaction function by central banks may change, and they may instead be more inclined to safeguard the integrity of the overall financial system rather than rapidly bringing inflation down to target levels. But in that case, more wealth destruction in the equity and sovereign and corporate bond markets would be assured, even with less hawkish – or even accommodating – central banks.
by Brunello Rosa
15 August 2022
The visit to Taiwan by US Speaker of the House Nancy Pelosi on August 2nd, and the reaction to that visit by the Chinese authorities, were widely reported upon by all media outlets. Pelosi had programmed her visit for April 2022, the first trip by a senior US lawmaker since House Speaker Newt Gingrich’s visit in 1997; but her trip was cancelled due to Covid-19. Already at that time, the Chinese Ministry of Foreign Affairs said that the visit was a “malicious provocation” and that the People’s Republic of China (PRC) would “take strong and resolute measures to thwart any interference by external forces”.
In effect, the reaction by the Chinese authorities was resolute. On 1st August, the PRC announced a military exercise opposite Taiwan. A military build-up was also seen in cities and on beaches directly opposite Taiwan. The Chinese military has also continuously sent fighter aircraft and naval ships over the median line and into the Taiwanese Air Defence Identification Zone (ADIZ). These drills have also been planned for areas east of Taiwan. During Pelosi’s stay, various Taiwanese government sites were hit by DDoS attacks, bringing down the Office of the President’s website, the Ministry of Defence website as well as the website of the Taoyuan International Airport.
Since the Russian invasion of Ukraine, many commentators said that China was keen to establish a new, privileged relationship with Putin’s country because this invasion would legitimise, at some point, the Chinese invasion of Taiwan. But things are a bit more complicated than this.
First, already in July 2021, six months before Russia’s invasion of Ukraine, we said that China would aim at taking back the “rebellious province” of Taiwan over the next 5 to 10 years, initially with a series of destabilising actions and provocations. The Chinese government will likely use a tactic not dissimilar from the one it adopted to take back control of Hong Kong.
Secondly, we said that China would not make such a move this year, as many had expected, simply because Chinese President Xi Jinping’s energy is devoted to being re-elected as party leader for the third time (effectively paving the way to a lifelong tenure as Chinese leader, irrespective of the official title) during the upcoming 20th Congress of the Chinese Communist Party (CCP). A war with Taiwan, which may have unpredictable consequences, would likely cause more harm than good to Xi’s hopes of re-election, paving the way for a victory of the opposing factions within the CCP, and in particular the faction led by Prime Minister Li Keqiang.
Third, and perhaps most importantly, when geopolitics is in flux, unexpected events may develop which make “mechanical inferences” less obvious than they would seem to be, prima facie. For example, recently Putin – the arch-enemy of the enlarging NATO alliance – and Erdogan, the President of Turkey, a long-time NATO member, decided to deepen the economic ties between their respective countries. Initially Erdogan established himself as the mediator between Russia and the West to free the grain stuck in Ukrainian ports (chiefly Odesa) besieged by the Russian army.
But during the meetings, which led to a partial unfreezing of those crops, badly needed to avoid famine in many African countries, Erdogan and Putin clearly found time to speak about their own respective interests. Although not many details were released of the intended increased cooperation, Western countries fear that Russia may find a way to circumvent the West’s sanctions, and that Turkey may be less aligned with the rest of the alliance in its opposition to Russia.
This example shows how the war in Ukraine, which has polarised the world, has set in motion the entire geopolitical landscape, and that – in any case – a new world order is likely to emerge in coming years.
by Brunello Rosa
08 August 2022
At the beginning of H2 2022, the world’s largest central banks have all delivered substantial monetary policy tightening. The first of these (in chronological order) was the European Central Bank, which on 21 July delivered a 50bps rate increase, bringing the deposit rate back to zero, despite expectations of a 25bps initial increase in all three rates of the so-called “corridor”.
There were two main motivations behind the ECB’s decision. First was that inflation surprised on the upside compared to the forecasts released just a few weeks before in the June macroeconomic projections. Second was the simultaneous introduction of the Transmission Protection Mechanism (TPI), which is designed to reduce the fragmentation in the transmission of monetary policy. Without that instrument, the ECB should have been much more cautious in increasing rates, as the sovereign yields of the most fiscally-exposed countries (chiefly, Italy) were increasing much more than was warranted by expectations of a tighter monetary policy stance.
After the ECB, the Fed, at its July 20 FOMC meeting, carried out its second 75bps rate increase in a row, the first having beendelivered in June. This was motivated by the need to bring rates into neutral territory (the upper end of the Fed funds corridor is now 2.50%, in line with the “longer end” forecast for the policy rates in the SEP dots), as inflation continued to surprise on the upside. Additionally, the Fed has also speeded up the pace of reduction of its balance sheet, to increase the overall amount of tightening in its policy stance.
Somewhat paradoxically, the market welcomed this second larger rate increase with a relief rally, as the Fed also changed its forward guidance. Chair Powell said that the Fed will not provide multi-meeting guidance anymore, as the FOMC will instead decide meeting by meeting, as it has become data dependent. However, the latest very strong Non-Farm-Payroll figures for August, showing a 528K addition of jobs (much more than the 250K expected and even above the 398K addition recorded in July), may induce the Fed to deliver another 75bps increase in September.
Finally, on August 4th, the Bank of England delivered a 50bps increase in its Bank Rate, bringing it to 1.75%, its largest rate increase for 27 years. Its Monetary Policy Committee, which had been split 6-3 in favour of a 25bps increase in June, moved to an 8-1 split for this larger move. This decision was motivated by the continued upward surprises of inflation, which is now expected to reach 13%, in spite of the incipient recession. In its latest Monetary Policy Report, the BoE now expects a contraction in economic activity to occur at the end of 2022, and to last for five quarters, one of the longest recessions in recent decades.
So, given the above background, with inflation continuing to surprise to the upside and labour markets still strong in the US, the EZ and the UK, it is likely that central banks will need to continue their job of reining in inflation with unrelented determination in coming months. The only element that could make them think twice is the beginning of the recession that some of them are predicting (while others are still, delusionally, denying that it will take place). A recession that may be caused, also, by the very tightening of monetary policy that central banks are undertaking in order to control inflation.
by Brunello Rosa
01 August 2022
Last week, the US recorded a second consecutive quarter of negative growth (-0.9 q/q SAAR), after Q1 1.6% contraction. Traditional economic theory would suggest that the US has entered a technical recession, however prominent economists and policymakers suggest this may not necessarily be the case. Former US Secretary of the Treasury Lawrence Summers said that the US is not in a technical recession because the largest negative contribution to GDP growth came from a drawdown of inventories, which is partly a sign of the economy’s strength. In effect, inventory decumulation provided a -2% contribution to Q2 growth, while export and consumer spending provided positive contributions.
Previously, Federal Reserve Chair Jay Powell saidthat, even in the case of two consecutive quarters of negative growth, the US would not be in a technical recession because the first quarter’s negative figure may be due to residual seasonality (and may be revised subsequently), and that the broad-based contraction in economic activity that is typical of a recession is not yet there, in spite of the clear weakening of growth observed by the central bank in Q2 2022.
So, the question remains: are the world’s major economies entering a recession at some point this year? If inflationary pressures persist, if the energy crisis intensifies, and central banks continue to increase rates to combat rising prices, it is almost inevitable that between Q4 2022 and Q1 2023 a recession will begin. While a vast majority of economists expect that such a recession, if it does occur, will be shallow, Nouriel Roubini expects it to be sharp and prolonged, given the stagflationary global debt crisis that is accompanying it. Even if those conditions mentioned above do not materialise all at once, it will still be very difficult to avoid some form of hard landing, in spite of central banks’ best efforts.
Let us assume then that some form of recession will materialise between 2022 and 2023. What would the implications of this be for central banks and markets? Central banks would likely have to stop increasing rates, as the recession will cause the tightening of economic and financial conditions that central banks are pursuing with their current policy actions. Money market futures do predict that the Fed and the BOE, for example, will cut rates in 2023. We expect a deceleration in the pace of tightening from the Fed and the ECB towards the end of 2022.
As far as markets are concerned, investors celebrated Powell’s words accompanying the Fed’s second consecutive 75bps rate increase in July with a relief rally. Powell said that the Fed will decide its policy meeting by meeting, since it is data dependent; in the past, when central banks become “data dependent”, this has generally been seen as anticipating a shift in stance, in this case towards a less aggressive posture. So, is it possible that, even as the economy is about the enter its worst phase, financial markets will hit bottom and start recovering?
Well, yes, it is entirely possible that this will occur, given the asynchronous nature of the financial and business cycle. Financial markets tend to anticipate what happens to the real economy (and even more so the labour market, which is a lagging indicator), as they are able to immediately reflect new information into prices (if one believes in the “efficient market hypothesis”). Over the years, empirical models have been developed to formalise this relationship. For example, an inversion of the yield curve (as is the case in the US currently) is considered to be a predictor of an upcoming recession. Equity markets tend to hit bottom a few quarters before a recession ends (as happened in March 2009 in the US, for example). But even Hyman Minsky’s “financial instability hypothesis” suggests that the financial cycle turns well before business cycles do.
In coming months therefore we may observe financial markets bottoming out, while the economy tanks. There is one big caveat here, though. If the recession morphs into a systemic crisis, for example by triggering a stagflationary debt crisis – as Nouriel Roubini suggests may happen – then both equity and bond markets may experience another leg down, as commodity prices continue to increase given supply bottlenecks and the impact of the war in Ukraine.
by Brunello Rosa
25 July 2022
The last few weeks have been extremely intense from a political risk perspective. First (as we discussed in a recent column), the UK government nearly collapsed after a rebellion – almost a mutiny – of a large part of its components took place, which effectively forced Boris Johnson to resign from his position as leader of the Conservative Party. Johnson said he will remain as PM until a successor is found, which will happen on September 5th. Then in Italy a sudden government crisisinitiated by M5S leader Giuseppe Conte led to the dissolution of parliament and early elections, which will take place on September 25th. PM Draghi will remain in power until then, to discharge the government’s “current affairs.”
Incidentally, one may notice how Boris Johnson and Mario Draghi have been among the fiercest opponents to Putin in his war in Ukraine. The UK was certainly the largest provider of weapons to Kyiv. Italy has been the most decisive proponent of a European “price cap” on gas, a measure that requires the support of the US for an effective enforcement, which would damage Russia’s energy revenues far more than the embargo on oil imports, as the latter merely reduces the quantity of oil available and so increases the prices. These two fierce enemies of Vladimir Putin will be soon out of power.
The question is: who is going to come to power after these two leaders?
In the UK, it seems that the populist era is about to finish with the end of Johnson’s tenure in office. The race for succession in the Tory party is now down to two main candidates: Rishi Sunak and Liz Truss. The differences in policies between the two are not massive, but are still significant. Each candidate represents a different era of the Conservative party. Sunak supports a return of the “old” tradition of the Tory party of being fiscally prudent; it has led to the proposed increases in national insurance contributions to finance the expansion of the NHS after the pandemic, as well to as an increase in corporate tax rates. Liz Truss meanwhile speaks to the more neo-liberalist component of the party, which seeks lower taxes to boost growth.
In both cases however, it seems that the period of “comforting fairy tales” – to use Sunak’s expression in his letter of resignation from Chancellor – for example, of the positive impact of Brexit on the UK economy, is over with the end of Johnson’s populist premiership, and a return of a more pragmatic and less ideological Tory leadership is imminent.
In Italy the opposite seems to be happening. After 17 months of the technocratic government led by Mario Draghi, which allowed Italy to start reaping the benefits of the EU’s Recovery plan, all signals point to a possible victory of the centre-right coalition. Each component within such a coalition is a reason for concern, to say the least.
The old patriarch of the coalition, Silvio Berlusconi, is the man who brought back populism in Italy after the fall of the so-called first republic. His first promises now (to increase to EUR 1,000 per month each pension below that threshold) are already reminiscent of the famous “less taxes for all” of 1994, when he won his first election. Just to give an idea of what his return to power could mean, fulfilling that promise alone would cost at least EUR 60bn, three times what Italy will get from the EU if it respects all the milestones of the Recovery plan by December.
Matteo Salvini’s Lega meanwhile continues to have anti-Euro positions even after participating in Draghi’s government. Those positions already led to a large widening of bond spreads in 2018, at the time of the M5S-Lega government. Finally, Giorgia Meloni’s Brothers of Italy, which enjoys the leading position in voting intentions (around 23-24%) according to recent polling, is an almost unknown quantity. As the New York Times recently said (in an article titled “The Future Is Italy, and It’s Bleak”), what most people know about Meloni and her party is that they come from the post-fascist tradition, and that its economic plans are obscure.
Clearly there is a risk of a return to populism with a vengeance after the September election in Italy. Such a return would likely lead to a renewed widening of intra-EMU spread, which the ECB will have hard time to consider “unwarranted,” as it did already in 2018.
by Brunello Rosa
18 July 2022
A government crisis occurred in Italy last week. The Five Star Movement (M5S), a major component of the national unity parliamentary majority, did not participate in the confidence vote over the Draghi government’s large package of fiscal aid for households and businesses hit by the cost-of-living crisis. The M5S’s parliamentary group had recently splintered as the faction loyal to foreign minister Luigi Di Maio formed a new group (Insieme per il Futuro, IPF) to support Draghi in his anti-Russian and pro-American stance.
Theoretically speaking, Draghi, having received the confidence vote both from the Chamber and the Senate (in this latter case, with an absolute majority), could have continued to govern and disregard this rebellion. But Draghi wanted to highlight the political relevance of the event. He went to Italy’s President Sergio Mattarella to resign, but Mattarella rejected the resignations and invited Draghi to go back to parliament this Wednesday, to “verify” the existence of its parliamentary and political majority. What will happen next?
Draghi is reportedly tempted to give up. Apparently he is tired of the cross-vetoes on all major pieces of legislation from the parties supporting his government. We anticipated that the various components of his composite majority could start dis-engaging with one another by autumn or winter, as the 2023 elections approached. But clearly the M5S wanted to exploit the first-mover advantage and leave the majority before anyone else, to spend a few months in opposition and regain the sort of anti-system credentials it has often had before the general election.
The problem is that, once a component element of Draghi’s parliamentary majority leaves, there is a strong incentive for all other components to do the same, instead of being held responsible for continuing to support a semi-technocratic government, even if for the greater good of the country. Thus Draghi will either manage to obtain a strong commitment from all remaining parties (and the component of the M5S that is still loyal to him), that they will support his government until the end of this parliament, without undermining his action with continued cross-vetoes – in which case the government will carry on – or else Draghi will clarify in parliament that the conditions to continue his tenure do not exist anymore, and he will resign.
Whatever happens, something is clear: political risk is on the rise in Italy. And with it, the 10y BTP-Bund spread, which has reached 220bps recently. And all this is happening during the week in which the ECB is expected to unveil its new anti-fragmentation facility, which is aimed exactly of containing the widening of spreads, when unwarranted by fundamentals. Italy is expected to be the largest and most relevant beneficiary of this facility. And just at the time when the technocrats in Frankfurt need to decide the crucial details of this facility, Italy is providing a clear example of a warranted increase in its sovereign yields and widening of the spreads, justified indeed by the rise of domestic political risks.
Italy is also supposed to be the largest recipient of the recovery funds from the EU, agreed upon during the pandemic. These funds can only be unlocked if Italy approves the necessary reforms, with the last batch expected to be finalised at the end of the year.
So, in theory money could be ready to help Italy recover from its traditional economic underperformance and defend its sovereign bonds from speculative attacks. But the recent political turmoil risks jeopardising this favourable course of action. Clearly, the events of these days are not bringing any favour to the count.
by Brunello Rosa
11 July 2022
Last week’s news extensively reported on Boris Johnson’s resignation as leader of the UK Conservative party. Johnson said that he will remain Prime Minister (PM) until the Tory party identifies his successor, who (by way of the UK’s unwritten constitution) will also become Britain’s new PM. In theory, this will happen by the time of the Tory party conference, which is scheduled to take place in Birmingham between October 2nd and 5th 2022. But the Labour and SNP opposition may push a confidence vote through parliament in order to speed up the substitution process. We suspect however that the conservative MPs will manage to avoid that; Johnson’s resounding victory in December 2019 gave the Tories their largest parliamentary majority since 1987.
The list of candidates vying to succeed Boris Johnson is a long one. The first to present his candidacy was Rishi Sunak, the former Chancellor of the Exchequer. His and Sajid Javid’s resignations triggered the collapse of Johnson’s government, and he is probably one of the most credible candidates alongside Ben Wallace, the Defence Minister, who is reportedly loved by the party base (but Wallace rule out his candidacy). Other competitors are Sajid Javid himself, the former Health Minister, who will run together with Jeremy Hunt(who was defeated by Johnson in the last leadership race) and Liz Truss, the incumbent Foreign Minister. Inevitably, other names will appear on the horizon as we approach the party conference.
Boris Johnson’s legacy will be that of leaving behind a divided country, politically and geographically. His main success might have been that of “Getting Brexit Done”, but this has also meant shovelling Brexit down the throat of two nations that voted against it, i.e. Northern Ireland (NI) and Scotland. As a result, Scotland has already started the process to hold another referendum for independence, after the one narrowly lost by the secessionists in 2014.
Northern Ireland meanwhile is constantly on the verge of a crisis, as the UK government has suggested the repeal of the so-called NI Protocol, which regulates the commercial relationships with the EU in the region (which imply customs check in the British Sea, to keep the border between Northern Ireland and the Republic of Ireland open). Additionally, the victory by the Sinn Féin in the recent elections in Northern Ireland has made a referendum on the reunification of the Irish island much more likely in coming years.
The Brexiter dream of launching a “Global Britain” after the UK’s divorce from the EU may ultimately lead to a return of the “little England” of the 1970s, facing the economic consequences of its departure from the bloc: endemic strikes, high inflation, slow growth, and increasing difficulties in remaining part of global supply chains (which are themselves in the process of becoming balkanised).
The task of the next UK PM, whoever that will be, and whenever he or she will enter office, will be that of “Making Brexit Work” for the UK: making sure that the country can reap the benefits of the regulatory divergence that it has fought so hard to achieve. Part of the task will also be re-building a relationship with the EU, which ought to be less fractious than the current relationship has been. The risk of not doing so would be to end up leading a country with much less influence on the world stage.
by Brunello Rosa
4 July 2022
Last week, a G7 meeting took place in Germany. According to its final communique, the meeting of these seven developed nations sent “a signal of clarity and strength” on crucial matters such as the war in Ukraine, world hunger, and other key long-term risks such as climate change. German Federal Chancellor Olaf Scholz stressed that “what unites [the G7 nations is their] shared values: democracy, human rights, peace and freedom.” For this reason, the G7 countries invited to the party “partner countries” such as “Argentina, India, Indonesia, Senegal and South Africa.”
As we discussed in our recent analysis, with the war in Ukraine, global governance has collapsed. The UN Security Council is balkanised like the rest of the world, with the US, UK and France on one side and Russia and China on the other side. Equally, the G20 is divided between supporters of the US and the West and those more inclined towards China and Russia (though there are a bunch of countries that would prefer not to take sides). For this reason, the G7 countries invited other partners from the developing world.
The G7 countries have also pledged to raise USD 600 billion in private and public funds over five years to finance needed infrastructure in emerging markets to counter China's multitrillion-dollar Belt and Road Initiative (BRI), in a newly renamed project called "Partnership for Global Infrastructure and Investment." If the extension takes place and gets implemented, this would amount to a new G7 gathering for developing economies, led by China. It would include countries with the largest populations in the world, and the largest natural resources reserves. With China’s BRI, which dates back to 2013, this new “EMG7” would have the firepower to compete on the international stage with the “traditional” G7.
Meanwhile, Russia has recently held its International Economic Forum of St. Petersburg, this year marking its 25th year. While one could think that, with the war in Ukraine, most world leaders would have deserted the forum and exposed Russia’s isolation, the Forum actually featured 13,500 participants from 141 countries and territories, with 43 foreign ministers and 1,500 companies represented at an executive level. At the forum, China, Russia and India discussed energy, supply and logistical corridors; the settlement of natural resources trading in currencies other than the dollar; the integration of the Eurasian geopolitical bloc with the Asian bloc; and even potential commercial agreements being reached between Pakistan and India.
Given this background, it is clear that a new model of global governance is emerging: one based on NATO and the traditional G7 to take care of the developed world, another based on the new EMG7 gathering, China’s BRI, and the military alliances that are being forged, which will primarily focus on developing countries. We could summarise this by calling it a “balkanised global governance for a polarised world.”
While all this is happening, China and Russia are not just staying put. Instead, on May 27 the Foreign Ministers of the BRICS forum countries (Brazil, Russia, India, China, and South Africa) “reached consensus on its expansion process”, so as to potentially include Saudi Arabia and Argentina in this group of countries in the future.
by Brunello Rosa
27 June 2022
After the French parliamentary elections that were held on June 12th and 19th, we are taking final stock of the long electoral cycle that took place over the past 2 years across the three major EU countries, Germany, France, and Italy. We previously carried out a similar exercise after the French presidential election took place, with our column on 9th of May 2022, but at that time the country’s parliamentary elections still lay ahead. We said then how Europe’s long electoral cycle, which started with the German general election in September 2021, followed by the Italian presidential election in January 2022 and the French presidential election in April 2022, had so far delivered a mixed result regarding the process of European integration.
We said then: “The results of this round of critical EU elections, which will finish this June with the parliamentary elections in France, has been something of a mixed bag thus far. On the one hand, traditional pro-European parties have “held the fort”, so to speak. On the other hand, this “fort” remains under the siege of the anti-European parties, which may want to stop the integration process, or even reverse it. A few years of high inflation, higher interest rates, low economic growth or recessions may change the tide in favour of these still-strong populist parties.”
The French parliamentary elections have now delivered a blow to the EU integration process, at the “last curve” of this electoral cycle. As we discussed in our Viewsletter last week, Macron’s party won 245 seats (vs 289 needed for a majority), Mélanchon’s left-wing coalition NUPES won 131, Le Pen’s party got 89 seats and the Republicans got 61. All other parties combined won 51 of the seats.
These electoral results meant that Macron only had two options. Either he could try to form a coalition with the Republicans in order to have a stable majority in parliament, or else he will have to seek a different majority for each law that will need to be passed by parliament.
After the first round of consultations, it seems that the first route is difficult to implement, as Christian Jacob - the head of the Republican party - said that he wants the party to remain in opposition. But finding a majority with “variable geometries” for each new piece of legislation will also be complicated – it means that the President may have a very difficult time translating his agenda into law.
The French constitution allows an extensive use of the confidence vote (article 49.3) to allow the government and the president to get his or her agenda through parliament. Still, without a solid majority, it is a very risky strategy to forgo a coalition. Alternatively, the President may dissolve parliament in coming years, but this may also result in a further erosion of Macron’s parliamentary support, in favour of the far-right, the far-left and the moderate right. So, Macron will have to thread very carefully in coming months and years.
More so than the domestic agenda, such as the long-waited reform of the pension system, which will suffer, the advancement of the EU integration process is at risk. Macron has clearly been the stronger voice against Russia within the EU, but also with Russia (given his communication channel with Russian President Vladimir Putin) in the Ukrainian war. And he was speaking as the de-facto leader of Europe. A weaker French president will not be able to play the same role as convincingly.
Any chance of further EU integration will also necessarily be impacted. We have already seen in the past that when France is against further integration, as for example was the case with the referendum on the EU Constitution in 2005, the process collapses. With almost 90 MPs, Le Pen can now credibly say that she is not representing a fringe movement anymore, but rather is reflecting the needs and desires of a large component of the French electorate.
by Brunello Rosa
20 June 2022
All of the largest and most influential central banks in the world held their policy meetings in the last couple of weeks. The US Federal Reserve adopted the largest increase in its policy rate since 1994 last week, with a 75bps increase taking its Fed funds target range up to 1.50-1.75%. Until a couple of days before the meeting, the Fed seemed to be excluding such a possibility. But then the May inflation figures, showing CPI at 8.6%, a 40-year high, convinced the Fed to adopt the emergency measure of increasing its target range so quickly (as did the inflation expectations gauge measured by the University of Michigan survey, which showed the potential of an initial de-anchoring). This move by the Fed may be replicated in July, if inflation prints do not start to convincingly and steadily decrease.
Also last week, the Bank of England increased its Bank Rate by 25bps to 1.25%, marking the fifth consecutive rise since December 2019. Again, the choice was motivated by the latest figures on inflation, showing an increase in CPI by 9% y/y in May. Three out of 9 Monetary Policy Committee members would have preferred a larger increase in policy rates, of 50bps to 1.50%. But the majority of the MPC preferred a more cautious approach, given the risk of recession highlighted in last month’s Monetary Policy Report. Similarly, the Swiss National Bank (SNB) increased its policy rate by 50bps, to -25bps; a surprise move, marking the first rate increase in 15 years. The SNB feared a de-anchoring of inflation expectations, even if that meant a temporary strengthening of the CHF.
To conclude the week, the Bank of Japan went in the opposite direction, and left its policy stance unchanged, undeterred by the peer pressure. In effect, Japan faces a different combination of impacts from the war in Ukraine and the pandemic on its growth and inflation outlook, and can afford to keep its policy stance much looser than other major central banks.
Finally, the ECB held an unscheduled policy meeting on Wednesday, which followed the regular meeting in June that clearly left the market unsatisfied. On June 9th, the ECB announced two rate increases in July and September, to combat inflation. But kept its “constructive ambiguity” on what it would be prepared to do in case fragmentation in the transmission mechanism of monetary policy were to emerge. Following the meeting, intra-EMU spreads rose again, with the BTP/Bund spread at 10y maturity reaching levels (above 200bps) last seen in 2018-19 during the Conte 1 government, supported by the euro-sceptical majority Lega–M5S coalition.
During the emergency meeting, the ECB’s Governing Council decided to task the relevant Committees with finalising the design and implementation of a new facility specifically aimed at reducing the fragmentation of the transmission mechanism (and therefore the intra-EMU spreads). In our preview, we mentioned how we thought that the “constructive ambiguity” approach was certainly insufficient to prevent the market from testing the ECB’s anti-spread resolve, and that a much more explicit reference to a facility explicitly aimed at reducing the market fragmentation was needed. The ECB thought initially that they could do without it, but then had to capitulate under the pressure of the market. In July they will probably reveal what this facility is about.
by Brunello Rosa
13 June 2022
Last week, Money 20/20, the largest FinTech conference in Europe, was held in Amsterdam. One of the headline events at the conference was a panel discussion in which the projectcalled a “New Era for Money” was presented. The project aims at developing and implementing the first Digital Sterling (dSterling) pilot. As we discussed on our website, Project New Era is a privately-led initiative evaluating the path towards a retail Central Bank Digital Currency (CBDC) in the UK. A CBDC would be the digital version of a banknote, with still the liability of a central bank. The project proposes that there be closer public-private collaboration in order to address key challenges and open questions relating to CBDC development.
Project New Era will form the Digital Financial Market Infrastructure (FMI) Consortium, with the aim of keeping central banks, regulators, and government informed of progress. The consortium will issue Sterling, a digital settlement asset similar to a CBDC, to drive the pilot, which will focus on core design issues. Rosa & Roubini Associates are an independent advisor of the Project and the associated Consortium.
The panel discussion in Amsterdam brought to the fore the technical, regulatory, policy and political challenges that lie ahead for the formal introduction of a CBDC in the UK. They mirror the challenges faced by all private and public sector actors in other jurisdictions on the introduction of a CBDC. In future reports we may discuss all this in more detail. In this column, we want to highlight one specific aspect of the adoption process: the reluctance felt by so many central banks in even engaging with the issue.
Just to give an example, the Reserve Bank of Australia (RBA), in September 2020 declared that “the Bank's view is that there is currently no strong public policy case to introduce a CBDC for retail use,” for various reasons including the still-strong demand for AUD banknotes, the availability of an electronic payments system and the cost of the exercise. Since then, the RBA has introduced a number of projects to study the potential adoption of a retail CBDC, but officially their position has not changed.
It is estimated however that around 80% of central banks are studying the introduction of a CBDC, and some of them have already begun issuing it. First and foremost, the People’s Bank of China (PBoC), which issued its e-CNY on the occasion of the Winter Olympics in Beijing. After this event, the US Federal Reserve speeded up its project for the introduction of a digital dollar in the US, following President Biden’s executive order on a Responsible Development of Digital Assets on March 9th. In particular, Rep. Lynch introduced legislation to develop an electronic version of the U.S. Dollar, in a pilot program.
In the UK, there seems to be a gap between what the Treasury wants to do, namely to make the UK become a global hub for crypto assets, and what the Bank of England is prepared to do. The BoE’s approach seems more cautious than that of the Treasury, at this stage. In Europe, while the Riksbank is in the forefront for the introduction of its e-Krona, the ECB has just launched a 2-year investigation period for its own CBDC.
Several industries have of coure already been disrupted by the introduction of digitalisation. We used to write letters, now we write e-mails; instead of phone calls on a landline, we now make video-calls on mobile phones. In the digital era, in which payments are made electronically and new forms of digital payments are introduced through crypto-assets and stablecoins, central banks will have to introduce the digital version of coins and banknotes, i.e. CBDCs. The PBoC has understood this before anyone else. It started its projects in 2014, and has already issued its digital renminbi. By doing so, it is gaining a massive competitive advantage on other central banks, including from a geopolitical perspective. So, the sooner reluctant central banks will realise introducing CBDCs is an inevitable process, the better.
Put in simpler terms, regarding CBDCs, it's not a question of IF, but of WHEN, and maybe, HOW.
by Brunello Rosa
6 June 2022
Press reports inspired by conversations with Chinese officials emerged last week, indicating that Russian officials were “increasingly frustrated” because China was not offering the type of support they had been expecting to receive from their powerful new ally. As a result, discussions between the two sides have been “tense” recently. In particular, China has reportedly not be offering the military support that Russia was looking for. This is somewhat confirmed by the words of the US secretary of state Antony Blinken, who said that the US has not seen “a systematic effort” by China to help Russia evade sanctions, nor any significant military support from China to Russia.
Theoretically, China could buy some of Russia’s USD 130bn holdings of gold held by Russia’s central bank, and pay for it in US dollars. It could reactivate a currency swap line which was established after Russia’s annexation of Crimea in 2014, and it could serve as a lender of last resort to Russia. China could increase its purchases of natural resources from Russia (primarily oil, gas and industrial metals), or buy shares in some of Russia’s critical state-owned enterprises. China has in the past helped Iran to evade some of the US’ sanctions by using some of its smaller banks. In our recent column, we said that China could offer, and likely has offered, Russia use of its international cross-border payment system (CIPS), instead of SWIFT, from which it has been banned by Western countries.
This bout of frustration for Russia may come as surprise news in the same weeks in which Russia and China, through the respective Foreign Ministers Wang Yi and Sergei Lavrov, pledged to continue working together to establish “true democracy in the world, based on countries’ own conditions.”This declaration of intent is the logical follow up to the solemn joint statement made by Xi and Putin on February 4th, which began with the surprising sentence (for two autocratic leaders) that “democracy is a universal human value, rather than a privilege of a limited number of States, and that its promotion and protection is a common responsibility of the entire world community.” There is clearly an attempt by Russia and China to re-define what democracy is.
While these developments are obviously puzzling, we are not surprised by this apparent contradiction for several reasons.
First, China does not want to end up being caught by the US sanctions against Russia, which as usual carry a great deal of extraterritoriality. The US and Europe combined are still the destination for around 35% of Chinese exports, at a time when domestic growth in China is severely impacted by a) the lockdown imposed as a result of the zero-Covid policy; and b) the effects of the campaigns against tech companies, private education, and real estate developers, among others. So, China cannot really afford to substitute two of its largest trading partners with a small and declining economy such as Russia.
Second, we have already questioned the rationality of Xi’s decision to choose Russia as its ally in Cold War II against the US, considering how unpredictable Putin is, especially if he really is being affected by serious diseases, as some reports suggest. Unsurprisingly, now reports are starting to be published questioning Xi’s physical and mental health, and his fitness for the top job. They are published by Chinese sources, however credible, living abroad and anonymously republished in mainland Chinai mainland China.
Third, we must take into account the ongoing power struggle in China ahead of this autumn’s congress of the Chinese Communist Party, which will choose the Party’s official leadership, with Xi running for a third mandate in the first official step of establishing himself as leader of the country for life. If this happens, this would mark the interruption of the mechanism adopted since the 1980s to choose the country’s leader, in which the president and prime minister serve only two five-year terms (with the prime minister then touted to succeed the president at the end of his second mandate). Numerous reports suggest that Premier Li Keqiang could be getting ready to succeed Xi later this year, by capitalising on the widespread discontent caused by Xi’s anti-graft and Zero-Covid campaigns, which have - according to Li - greatly damaged the economy (which he is officially responsible for). So, Xi needs to show that his choices are still rational and not dictated by the needs of Putin, whose judgment abilities may be compromised.
All this suggest that the first cracks may start emerging in the new alliance between China and Russia, which was in effect supposed to be limitless. The front of the two autocracies within the UN Security Council may not be as united as Xi purported it was when he called US President Biden to congratulate him for his victory in 2020. On that occasion, Xi reportedly told Biden that “autocracies, not democracies, will run the world in coming decades,” as in an increasingly complex world in rapid evolution, quick responses were needed. But “democracies require consensus and consensus takes time to build, but countries have no time.” When reporting on the content of his conversation with Xi, Biden concluded that Xi was “wrong.” Perhaps these recent tensions between China and Russia prove that democracies will be able to survive as an effective way of governing for a bit longer
by Brunello Rosa
30 May 2022
Oil prices have risen substantially in the last couple of years. In April 2020, at the beginning of the pandemic, Brent crude oil was trading just above USD 20pb (after having dropped briefly into negative territory, as the price of storage soared as a result of widespread lockdowns that prevented super-tankers from docking in ports). Currently oil prices are trading well above USD 110pb, as a result of the reopening of economies and, especially, the war in Ukraine and the further disruption in global supply chains. Lockdowns in China, commanded by the ill-conceived Zero-Covid policy, have disrupted the port of Shanghai, and are making the situation worse.
For gas prices the situation is similar. The US liquefied natural gas exports price is currently trading at 10.17 USD per thousand cubic feet, up from 8.56 last month and 6.52 one year ago. This is a change of 18.81% from last month and 55.98% from last year. According to the EAI, natural gas spot prices are rising at most locations. The Henry Hub spot price for example rose to $9.30 per million British thermal units (MMBtu) last week, from $8.45 the previous week. These increases are completely attributable to the war in Ukraine, as gas had continued to circulate freely during the pandemic.
The negative supply-side shock represented by the massive increase in energy prices discussed above will have its traditional impact on the economy: it will reduce economic activity while increasing price inflation. This will be felt more strongly by those countries more dependent on energy imports, such as Eurozone countries, with Germany and Italy the most reliant on Russian gas imports. Various national governments have tried to reduce the impact on households and companies with tax rebates and the freezing of fuel duties. But at EU-wide level, a different solution is emerging.
In Brussels, there are two lines of thought regarding this subject. One is that there should be an embargo on oil and gas imported from Russia. The other is that there should be a price cap; a limit on the amount the EU can spend on oil and gas imports. So far, the idea of the embargo is having the upper hand in the discussion, as politicians believe it is the quickest way to stop financing Putin’s regime and its war in Ukraine. But there is another reason why the Europeans prefer the solution of the embargo to that of the price cap.
The price cap solution was suggested to the Europeans by the US Secretary to the Treasury Janet Yellen, on at least two occasions (the latter occasion being the G7 meeting in Germany on May 18-20).
The proposal was to set a price limit to how much the EU would be willing to spend for oil and gas (a price cap), and the US would help enforce the cap by applying itself to its own trades. Also it would ask all its trade partners to help enforce the cap, in an extraordinary example of extra-territorial coordination of policies and sanctions.
Facing this generous offer, the Europeans preferred to opt for the embargo, to show some form of strategic autonomy from the US. In doing so, they choose an illogical solution from an economic standpoint. The embargo will reduce the quantity of energy in circulation and will increase oil and gas prices, as the Europeans will be forced to make agreements with other sellers. Conversely, the price cap would have kept the same amount of energy at Europe’s disposal, at a reduced price.
A third possibility that has been flagged recently is a sort of “punitive EU tariff on Russian oil, proposed by the US and others,” which would pave the way to an oil embargo at a later stage. According to its proponents an EU-wide tariff on Russian oil would “compel buyers to demand an offsetting discount from Russian sellers, cutting Moscow’s profit, or go elsewhere. A tariff that successfully forced Russia to cut prices would in effect transfer tax revenues from Moscow’s coffers to the EU’s.”
Regarding Europe’s strategic autonomy, the EU may decide not to follow the lead of the US on the price cap, but it will eventually be forced to follow the US lead on military strategy, which – as we discussed in previous columns – diverges from that of the Europeans, insofar as the US will want to continue the war for longer, whereas the Europeans are aiming at an immediate ceasefire, at almost any cost.
For the US, the war has produced the following tangible results: it has re-aligned its historical and potentially reluctant allies; it has induced the Europeans to contribute more to the NATO budget (a long-standing request by the US); it has led to an increase of NATO membership (with Finland and Sweden likely joining); and it has implied that the US will start exporting its energy (in particular LNG) to Europe. The Europeans, on the other hand, have a lot to lose from a continuation of the war, as they are the most exposed to the sanctions, and to the “collateral effects” of the war, such as the rise in refugees. Since the war has polarised the world, the dream of the European strategic autonomy by way of the EU, or even of a European neutrality between US and China, has clearly vanish.
by Brunello Rosa
23 May 2022
As we discussed in last week’s column, markets are in turmoil as recession fears increase around the globe. Central banks had thought that inflation would be a temporary phenomenon due to transitory factors, but instead it proved to be a persistent feature of the post-pandemic world, exacerbated by additional supply-chain constraints and the rise in energy prices due to the war in Ukraine. As a result, they have all turned hawkish (with a few exceptions, such as the BOJ) and started policy normalisation programs.
Now central banks are assuring the public that a recession will not take place as a result of the series of shocks that have hit the global economy, but they are also warning that they cannot guarantee a “soft landing” will take place. Hence the market now fears that a recession may in fact occur at some point in 2022. This is causing a free fall in equity indices, with the S&P now exhibiting the worst start to a year since 1939, entering a bear market. It is also causing a fall in long-term bond yields. As we discussed last week, this can be interpreted as the market fearing an outright recession more than a stagflationary shock, as the contraction in economic activity would tame inflation somewhat by reducing aggregate demand.
A combination of lower risky asset prices, economic deceleration and rising recession fears may induce central banks to adopt less aggressive policy normalisation plans than initially anticipated. At the same time, their normalising rates and withdrawing liquidity at the time the economy is wobbly may be a very risky strategy, especially at a time when governments are also considering fiscal consolidation plans. For example, the final communique of the G7 meeting held in Germany at the end of last week, under German leadership and presided over by the German Finance Minister Lindner, called for a reduction of the debt that states had accumulated to fight the pandemic.
This combination of higher inflation and policy interest rates, reduced economic growth (or even recession), high public indebtedness and reduced central bank liquidity could be particularly dangerous for the most fragile countries.
In the Eurozone, for example, Italy has already witnessed a sizeable increase in its yield spreads versus Germany in the last few weeks (with the 10y yield spread having surpassed 200bps), a larger widening than that experienced by similar countries such as Portugal and Spain.
In September 2019, while the Fed was implementing its first round of Quantitative Tightening (QT), at some point the reduction in liquidity proved excessive. As a result, the US Treasury market became really unstable, with long-term treasury yields spiking. The Fed had no other option than interrupting its QT program and re-starting asset purchases again (in this case, for the smooth functioning of the transmission mechanism of monetary policy).
This may happen again in the US and in other jurisdictions, chiefly in the UK and in the Eurozone. In particular, in the Eurozone, the ECB has not specified whether a new facility to keep the intra-EMU spreads will be launched at the time QT is announced. For now, the ECB prefers to continue to keep some form of “constructive ambiguity” regarding this choice, preferring to say that, at the right time, the ECB is ready to re-start the Pandemic Emergency Purchasing Program (PEPP), or to use its re-investment policy to keep the spreads in check, or to come up quickly with a new facility. This choice is also motivated by the decision to avoid any legal challenge related to the adoption of a new instrument by the Governing Council.
Some analysts suggest that a new version of the Outright Monetary Transactions (OMT, with lighter conditionality) may be used in this case. But the positions within the Governing Council clearly differ. However, time is running out. If the ECB intends to end its net asset purchases in June and start increasing rates in July, when market liquidity will be further reduced by the summer season, one cannot rule out a market accident involving the most indebted and more fragile countries such as Italy. So, it may be preferable for the ECB to specify what it intends to do in case an unwarranted increase in spreads occurs, instead of rushing to find a solution after a market accident has already occurred.
by Brunello Rosa
16 May 2022
Last week, financial markets were in turmoil once again. Global equities decreased on a weekly basis, with the MSCI ACWI index down by -2.2%, the US S&P 500 index dropping -2.4% and the MSCI EMs falling by 2.6%. With this week’s negative performance, this year is the second worst start to a year for the S&P 500 in history: -17.5% in the first 91 trading days. Logically, volatility has also risen considerably, with VIX rising to 29.35 (versus a 52-week average of 21.7 and a 10y average of 18.0).
Volatility in markets is increasing as investors are becoming sceptical that central banks will be able to engineer a ‘soft landing’ for the economy after the series of rate increases that they are planning to implement in coming months in order to tame inflation. Reasons for concern abound, as investors have suffered from: i) the accelerated pace of monetary tightening that most central banks have announced, most recently the ECB, which may be increasing rates already in July; ii) geopolitical news, with Russia threatening a retaliation to a possible admission of Finland and Sweden to NATO; iii) persistently high inflation data; iv) the impact of strict lockdowns in China, which are further disrupting global value chains; and v) increasing recession fears as the global economy is slowing down.
However, last week, something different from previous weeks occurred. US government bond yields (especially in the US and the eurozone) fell amid the sell-off in equity prices. So, the correlation between bond and stock prices went back to negative after being positive recently. Finally, credit spreads widened, with the effective yield on US “junk bonds” (US High Yield Master II) reaching 7.4%, the highest level since May 2020. All this while bank equity prices continue to fall, with the shares of the five largest US banks down between 20% and 25% year-to-date.
How can we interpret all this? In the stagflationary scenario that we have observed so far, the combination of higher inflation, lower growth and higher long-term rates, have led to a parallel decrease of bonds and equity prices (positive correlation). But the increase in recession probability means that inflation may be lowered by the reduction of the demand side of the economy, making stagflation fears less pressing. As a result, there start to be risk-off flows into government bonds, thus lowering their yields.
Additionally, rate increases tend to be good for banks, as they steepen the yield curve on which they profit with maturity transformation. But if rate increases risk causing a recession, the weakening of the economy would be bad for bank profitability. As a result, bank equity prices fall.
In all this, price movements have been exacerbated by the sharp sell-off in the crypto-currency space, where Bitcoin has fallen below the psychological barrier of 30,000 and lots of stablecoins went under stress, with the Terra/Luna trade collapsing and even Tether shortly falling to 95.11 cents on the dollar. With USD 80bn held in assets as collateral, sharp liquidations to keep the peg at 1$ would eventually also impact traditional markets, not just the USD 1.3tn crypto-asset market.
by Brunello Rosa
9 May 2022
In February 2019 we identified the round of elections taking place between the German general election in September 2021 and the French parliamentary election in June 2022 as being crucial to determining the future of the EU integration process. Now, as we approach the end of this round of elections, we want to take stock of what has happened thus far, to revisit our earlier views on the subject.
The German general election (September 2021). The German election resulted in a collapse of the CDU. The CDU was narrowly overtaken by the SPD, which was able to form an unconventional “traffic light” coalition with the Greens and the Liberals. So far, this coalition has managed to navigate both the last phase of the pandemic and the war in Ukraine with relative tranquillity. The pro- European and Atlantic credentials of Germany have been re-affirmed, and the extreme wings of Germany’s political spectrum have been left out of government. However, the fragmentation of the political system, with the collapse of traditional parties, is not reassuring for the stability of Germany, the key pillar of the EU and Eurozone.
The Italian Presidential election (January/February 2022).The Italian Presidential election resulted in a non-event, with the re- election of Sergio Mattarella as Italy’s head of state for another 7-year term. His re-election, coupled with the permanence of Mario Draghi as PM, for now reassures Italy’s allies regarding its Atlantic ties and pro-European stance. On the other hand, the fact that Mattarella may not remain in charge for the entire duration of his second mandate does not guarantee that Italy will elect a pro-European President during the next parliament, if a Lega-FDI majority were to emerge after the general election of February/March 2023.
The French Presidential election (April 2022). As we discussed recently, Macron’s victory is certainly the best reassurance that the EU integration process will continue (in the areas of defense, security, and migration policies, for example), however slowly. But it is a fact that the majority of Macron’s voters were over-60-year-old pensioners. At the same time, with 41.5% of the vote, Marine Le Pen has gathered the highest number of votes for a right-wing candidate since the beginning of the country’s Fifth Republic, and did so with a much larger geographical dispersion of the vote share than in previous elections. This is already the third time a Le Pen has reached the second round of the presidential election. In 2002 Jean-Marie, the father of Marine, lost to Jacques Chirac; in 2017 and now again in 2022 Marine has faced Emmanuel Macron in the second round of the presidential election. In each of these appearances the far right has increased its votes, both in absolute terms and as a share of total votes cast. One cannot rule out that Marine Le Pen may win the election in 2027, considering that Macron will be blamed for all the misfortunes French people may experience in the meantime. A Le Pen victory would represent a total regime change in France, which would put the EU integration process in peril.
As mentioned above, the results of this round of critical EU elections, which will finish this June with the parliamentary elections in France, has been something of a mixed bag thus far. On the one hand, traditional pro-European parties have “held the fort”, so to speak. On the other hand, this “fort” remains under the siege of the anti-European parties, which may want to stop the integration process, or even reverse it. A few years of high inflation, higher interest rates, low economic growth or recessions may change the tide in favour of these still-strong populist parties.
by Brunello Rosa
2 May 2022
We have discussed in previous columns that the war in Ukraine has contributed to the world becoming polarised into two camps: the US and its allies, including the EU and other European countries, on the one hand; China, Russia, and their allies (including Iran, North Korea, and Pakistan, for example) on the other hand – with India having to choose between the two camps.
We have also discussed the two lines emerging within the Western alliance. The EU is more inclined to reach an immediate ceasefire between Russia and Ukraine, even at the cost of freezing the situation temporarily in an unstable equilibrium which Russia may be tempted to break 2-5 years down the line. The US however is more inclined to keep the conflict going for a little longer (perhaps until the mid-term elections in November).
Within this framework, it becomes of paramount importance to determine the fate of Ukraine, regarding among other things its application to join the EU. There’s no point in discussing how to reconstruct Ukraine from an economic standpoint, if its geopolitical status has not been determined yet. More generally, it is absolutely vital to determine what geopolitical configuration Europe may have in coming decades. For this purpose, it may be useful to resurrect an idea I launched many years ago in several publications (including here and here).
In the aftermath of the Crimea annexation by Russia (just to remind ourselves how long ago this process started), Europe was also observing the rise of populism, at the same time in which secessionist regional forces were becoming stronger in places such as Northern Italy, Catalonia, Flanders, and Scotland. I suggested that two main policy actions and re-organisation processes needed to be implemented.
From a country perspective, countries had to be re-organised in concentric circles, with the inner circles being represented by the Eurozone and the EU and an outer circle being formed by countries which wanted some form of close cooperation with the EU without being formally part of it. Belonging to that circle there were countries such as the UK, Turkey, Albania and – hear hear – Ukraine (see picture above).
Given the strengthening of the outer borders of Europe, I suggested – in terms of internal organisation – to promote a gradual weakening of the internal borders within the EU, and the formation of cross-border macro-regions, with real decision-making power being pushed down closer to the population, as sovereignty was pushed up at supra-national level. Recently a similar proposal has been formulated recently by the leader of the Italian Democratic Party (PD) Enrico Letta, former Dean of the Paris School of International Affairs at Sciences Po (PSIA), who spoke about a European Confederation, which comprises non-EU members; and by a former Italian Finance Ministry Vincenzo Visco. But in the past the newly re-elected French President Macron also expressed similar ideas.
Given how the war in progressing, I believe the idea of re-organising Europe in concentric circles remains the only option if we are to guarantee long-term security and peace in Europe. Admitting Ukraine in the EU will remain a long and controversial process, and is not even a given that a EU accession by Ukraine would represent a positive step for the overall viability and solidity of the EU. Instead, promoting a form of strong association of the EU with Ukraine, as well as with other countries in the outer circle, such as the UK, Turkey and Albania, could help stabilise the geopolitical situation in the decades to come
by Brunello Rosa
25 April 2022
The IMF and World Bank held their Spring Meetings last week, once again mostly in virtual format with only a limited number of events held in person, due to the still-ongoing restrictions associated with the Covid pandemic.
As usual, the IMF released its updated forecasts in the World Economic Outlook (WEO). The WEO “certified” the stagflationary shock that hit the global economy as a result of the continuing impact of the pandemic and the simultaneous impact of the war in Ukraine and its related sanctions. Combined, these events represent a double negative supply-side shock, which tends to push inflation up and economic activity down. The latest issue of the WEO, titled “War Sets Back The Global Recovery”, says that “economic damage from the conflict will contribute to a significant slowdown in global growth in 2022 and add to inflation.”
More specifically, the IMF reports how “global growth is projected to slow from an estimated 6.1 percent in 2021 to 3.6 percent in 2022 and 2023. This is 0.8 and 0.2 percentage points lower for 2022 and 2023 than projected in January. Beyond 2023, global growth is forecast to decline to about 3.3 percent over the medium term.” Regarding inflation, the IMF says that “war-induced commodity price increases and broadening price pressures have led to 2022 inflation projections of 5.7 percent in advanced economies and 8.7 percent in emerging market and developing economies—1.8 and 2.8 percentage points higher than projected last January.” In its commentary, the IMF says that “fuel and food prices have increased rapidly, hitting vulnerable populations in low-income countries hardest.”
The meetings schedule also foresees discussions on the legacy of the pandemic on younger generations and on the labour market with two discussion panels titled “The COVID Generation: Offsetting Opportunity Loss for Youth” and “Labor Market Slack in Advanced European Economies & North America.” As discussed in previous columns, the phenomenon of the “great resignation” has led to a significant slack in the labour market, while having a negative long-term impact of the employability of the younger generations.
Given this economic backdrop, policymakers gathered in Washington DC had to figure out a policy response. At the “G20 Finance Ministers and Central Bank Governors” held in Washington under the rotating Indonesian presidency, G20 “members underlined the crucial role of the G20 as the premier forum for international economic cooperation to deal with the current multifaceted and complex global economic challenges.” In our recent article, we discussed how the ongoing polarisation of the world between US and China is leading to the ineffectiveness of international fora such as the G20 in dealing with ongoing policy challenges. It is good to see that central bank governors and finance ministers at least still believe in a multilateral approach to solving complex policy issues.
Having said this, as the communique says, “G20 members expressed concerns about the wider and persistent inflationary pressures. This condition will push central banks to increase their interest rate policies which in turn will result in faster-than-expected tightening of global liquidity.” So, as we anticipated in our recent analysis, even the G20 forum “sanctioned” that, at this time, central banks should focus on fighting inflation, while governments focus on supporting economic activity.
by Brunello Rosa
19 April 2022
The war in Ukraine is at a crucial point. The Russian army has found itself facing more resistance in its advancement than it had anticipated. It apparently failed to conquer Kiev on its first attempt. Therefore, it has recently focused its efforts on securing the areas that would guarantee territorial continuity between Crimea and the Russian motherland. In this respect, conquering Mariupol has become the near-term tactical objective of the Russian army. Russian President Vladimir Putin needs to flag some victory at the May 9thparade that celebrates the “Great Patriotic War,” i.e. WW2. In his initial plan, he might have wanted to celebrate the definite submission of the entire Ukraine by that date, but this objective is clearly unattainable at this stage.
Ukraine managed to stall the Russian invasion thanks to the substantial military aid it has received from NATO countries, which are providing weapons to its army and other supplies to the wider population to withstand the atrocities of the war. The US has already reportedly provided USD 3bn in direct and indirect support, while the UK’s navy seals are reportedly training the Ukrainian forces. In fact, for the time being, NATO countries have been providing Russian-made weapons to the Ukrainian forces. But in the future, Western-made artillery may need to be provided to the country under siege.
Two lines are clearly emerging within the Western alliance. European countries would be more inclined to press on the diplomatic channel, in an attempt to achieve a ceasefire sooner rather than later. The US, with the “weaponised rhetoric” of its president, is clearly not interested in making any sort of deal with Putin, which means a likely extension of the conflict. If Sweden and Finland were to join NATO, as flagged as a possibility by the two countries’ respective prime ministers, that might imply an expansion of the conflict, if Russia were to retaliate in the Baltic as was recently threatened by Putin.
Putin’s Russia can withstand the sanctions of the Western alliance for longer only if China will provide forms of direct and indirect support. There has been plenty of discussion about whether Putin is acting rationally or if he has already entered the typical end-phase of autocratic leaders, when they lose touch with reality and exhibit clear signs of “delusion of omnipotence.” Let’s assume that Putin’s actions are still borderline rational. In any case, he will remain a very difficult ally to control for China’s President Xi Jinping. Xi can at most “manage” Putin and the implications of his actions, but will not ever be able to fully control him.
But here is the real question. How rational is it for China to rely on Russia as an ally in its Cold War II with the US? After all, the principal destination of China’s exports remains the US and the EU. In a fully balkanised world such as the one that is emerging as a result of Cold War II, economies like South East Asia and even India (if it were to choose the Chinese camp, let alone an alliance with Russia) will not be able to replace the US and the EU as “consumers of last resort.” One therefore needs to wonder if Xi may also have entered the final phase of autocratic leaders, after the changes of the constitution that will allow him to remain in power indefinitely. These will take place just before this autumn’s key party congress, where Xi is seeking to be elected as leader for the third time.
People from China report a further “closure of the system” that has taken place in the last few years, as testified by the suppression of liberties in Hong Kong, for example. An old Chinese saying states: “When the sage points at the moon, the fool looks at the finger.” So perhaps when assessing the rationality of choices of leaders, one should not stop at looking at Putin’s “finger”, when instead Xi’s “moon” should be watched. With one frightening certainty in mind: while the West can barely contain Russia without triggering WW3, it will be much harder to contain China in coming decades, given the technological, economic, military and now geo-strategic advancements it has made in the last few years.
by Brunello Rosa
11 April 2022
Last week the UK government announced that it intends to issue regulations that will make the UK the global hub for crypto-finance. As part of this effort, the UK government will allow stablecoins to be recognised as a valid form of payment in the country. Regulatory measures will include legislation for a ‘financial market infrastructure sandbox.’ Additionally, the Chancellor has commissioned the Royal Mint to create a Non-Fungible Token (NFT) this summer.
This is a quantum leap in UK regulation, vis a vis the crypto-financial industry. So far, the UK has taken a very cautious approach towards the world of digital assets. Even central bank digital currencies (CBDCs), which have been studied in all major jurisdictions, including in the US and the euro-area, received a very lukewarm welcome by the House of Lords, which tellingly issued a report on them with the title “A Solution In Search For A Problem?”. Recently, the Bank of England has issued a report highlighting the financial stability implications of adopting crypto-assets and decentralised finance (de-fi) on a large scale.
The UK government has however clearly decided to change tack regarding this issue. Rather than demonize the digital asset revolution, the UK government is attempting to embrace it.
Already, there are forms of digital assets, such as CBDCs, that are openly studied by monetary authorities and regulators. So, as soon as all the numerous technical and legal problems affecting these will be resolved, we can be reasonably sure that central banks will issue them, the same way the People’s Bank of China did with the e-CNY.
Other forms of digital assets, such as stablecoins, are still under scrutiny, but will most likely become an acceptable form of payment relatively soon.
After all, some versions of these already exist as forms of payment - the fidelity points issued by airline companies, for example - even if they can be only spent in closed circuits. In this respect, the UK government’s decision to accept stablecoins as acceptable forms of payment will represent a turning point for most regulators around the globe.
What could be more surprising is the UK’s decision to include crypto-assets, sometimes labelled as crypto-currencies (which is a controversial term, considering that for most regulators, cryptos don’t have the three standard characteristics necessary to be considered a currency), in the new regulatory framework. What motivates this decision?
In our view, the UK government is trying to find niches within which they can apply the regulatory divergence with the EU that the country has recently earned the ability to carry out as a result of Brexit. Bio-tech and fin-tech are clearly areas that can be exploited in this regard, and therefore we are not surprised by this decision. If the UK government wants to make Brexit a success, it will have to show that it can exploit some competitive advantages, and the crypto industry represents a perfect opportunity to do so.
In the UK government’s view, it is not even necessary that crypto assets are actually viable, or even whether of not they are potentially illegal. As long as their financial activities are carried out in UK territory, the government believes it can control, steer and eventually regulate these activities. The UK government probably has the ambition of creating a City 2.0, in which the central role of London and sterling is re-established in the cyber realm. This may be an ambitious, aspirational or and even arrogant objective. But the UK has clearly shown that it intends to take a lead within this evolving environment.
by Brunello Rosa
4 April 2022
A bilateral meeting between China’s foreign minister Wang Yi and his Russian counterpart Sergei Lavrov took place in Beijing last week. This was the first bilateral meeting between the two sides since Russia’s invasion of Ukraine. Speaking in a video released by its ministry, Lavrov said that Russia and China are working together to establish "a multipolar, just, democratic world order". According to Lavrov, the world was "living through a very serious stage in the history of international relations", but that China and Russia, together with their “sympathisers, will create such a new world order". China’s Yi reiterated that China and Russia will continue to coordinate their foreign policies,and that will continue to “speak with one voice” on the world stage.
These sentences are a clarification and a further confirmation of the joint declaration that Chinese President Xi Jinping and Russian President Vladimir Putin signed on February 4th, on the sidelines of the Winter Olympics in Beijing. That statement also added that the bonds between the two countries have “no limits” and that “there are no forbidden’ areas of cooperation.” That joint declaration opens with a statement that sends shivers down the spine, considering that is signed by two autocratic leaders: “The sides [i.e. China and Russia] share the understanding that democracy is a universal human value, rather than a privilege of a limited number of States, and that its promotion and protection is a common responsibility of the entire world community.”
For those who are at loss here, this kind of language is not typically used in some second-tier commercial agreements, whereby the sides discuss “joint interests”, “commercial opportunities”, etc. This kind of language is used in game-changing declarations, aimed at profoundly modifying the status quo and opening a new phase in the world history. As we discussed in our recent article by John Hulsman, China and Russia are paving the way for the creation of a new, polarised world, in which the “Eastern” hemisphere, geographically dominated by Russia and China, will oppose the traditional “Western” alliance, comprising the Anglosphere (US, UK, Canada, Australia, New Zealand), the EU and Japan. In a previous column, we discussed how this is already having an impact on the international payment systems, with China’s CIPS gaining ground versus the Western-dominated SWIFT.
In this new polarised war, it is yet to be determined what side India wants to stay on. On the one hand, the US has forged the QUAD alongside India, Australia and Japan, an association of democracies in the Indo-Pacific area, which is widely considered an attempt to contain the growth of China’s influence in South-East Asia. The QUAD was revitalised at the time of the conflict between China and India in the Himalayas, when the tensions between the two countries reached a “local maximum.”
More recently, though, there has been a rapprochement between Russia and India, even if Russia is siding with China. India is a very large and populous country, and is one of the few remaining democracies in the region, even if Modi has adopted nationalistic policies with some autocratic traits. So, knowing which side it will be on in the future it will be important.
Nearby in the Middle East, numerous countries, especially those that are oil exporters within OPEC, have been very cautious and reluctant in openly condemning Russian’s invasion of Ukraine. They might have refrained from doing so for economic, or geopolitical, reasons. But we should never forget that there also exists a view of the world that does not coincide with that which is held by the West or the US. And considering this reality will become essential in the multi-polar world we are about to live in for the next few years.
by Brunello Rosa
28 March 2022
The war in Ukraine continues, resulting in thousands of victims, of soldiers and among the general population, causing widespread destruction and endless suffering. The Russian army is finding it harder to conquer Kiev and the centre of Ukraine than they initially planned, amid logistical difficulties and uncertainty regarding their strategy and ultimate mission. While the war rages on, diplomatic channels are open, but a diplomatic solution is also hard to find, especially given rhetoric that is further escalating tension instead of reducing it.
In the last few days there has been an escalation of rhetoric by the US administration that will make it extremely complicated to reach an agreement between Russian President Vladimir Putin and the West. On 21 March US President Biden, when asked whether Putin was a war criminal, after having initially said no, he returned to the journalist to say “yes, he his”.A few days later, the US ambassador to Moscow was summoned by the Russian foreign minister, who told him that this answer put Russia and the US on a collision course. On March 26, US President Biden further hardened the US rhetoric by moving away from the prepared written speech in Warsaw to say that Putin cannot remain in power. US Secretary of State Blinken rushed to give assurances that the US is not actually seeking a regime change in Russia.
Clearly, bombing cities and killing innocent civilians, as Putin has ordered his military to do, cannot be compared to the hardened rhetoric of the US president. But the implications of Biden’s choice of words could be equally devastating. To understand this point, it may be useful to remind ourselves the historical precedent of attempts made by the US and European nations in dealing with Germany’s Chancellor Adolf Hitler.
Before the Munich conference in 1938, it was already clear what type of character Hitler was, and what intentions he may have had in terms of re-militarising Germany and extending its dominion over neighbouring countries. In spite of this, European leaders met with Hitler in Munich, took pictures with him and even signed an agreement with him. UK PM Chamberlain returned from Munich sure of having “saved peace in Europe.”
But after the invasion of the entire Czechoslovakia (not just the Sudeten region, agreed upon in Munich) and then of Poland in 1939, it became clear that it was impossible to make agreements with Hitler, and that he needed to be removed militarily. No European, US or Soviet leader would have ever accepted signing a treaty with him, or be pictured beside him.
After calling Putin a war criminal, and after saying that he cannot remain in power, US President Biden has in effect crossed that line that makes it impossible for him to sign a treaty or be pictured beside Putin. Who could possibly want to be seen beside a war criminal, or legitimise him by signing a joint declaration?
The question now is: what are the consequences of all this? The most immediate consequence is that the war continues, and that even reaching a temporary ceasefire becomes virtually impossible. Also, if Putin fears that at the end of the war he may be called to respond to his “war crimes” by the International Criminal Court at the Hague, he may be tempted to take more risks, rather than fewer risks, in the short run.
Normal people may have instinctive reactions regarding the war, but policymakers should be more careful in their choice of words. Biden’s hardened rhetoric, while certainly emboldening the Ukrainian resistance and uniting the NATO front, makes it harder to reach a conclusion of this conflict in the short run.
by Brunello Rosa
21 March 2022
The US Federal Reserve increased its Fed funds target range by 25bps last week, to 0.25%-0.50%. The Fed also indicated that it could implement six additional rate increases this year, and three next year, and that it could start reducing the size of its balance sheet as early as May 2022. Additionally, the updated Summary of Economic Projections showed a median Fed funds rate at 1.9%, with a core PCE at 4.1% at the end of 2022, implying a negative real rate (of 1.2%) that indicates a still-accommodative monetary stance, which could be removed in coming months.
Also last week, the Bank of England increased its Bank Rate by 25bps to 0.75%, for the third consecutive time since December, taking the rate back to the level it was at pre-pandemic. While the tone of the accompanying statement was less hawkish than it had been previously, thanks in part to the dovish dissent of Deputy Governor Jon Cunliffe, the BoE might still increase rates in the upcoming May meeting, at the same time as it releases its next Monetary Policy Report (MPR). Otherwise one would not understand the reason to rush with a rate increase in a non-MPR month.
A week before these moves by the Fed and the BoE, the ECB ended its extraordinary pandemic-related PEPP program and accelerated the pace of tapering of its net asset purchases (which could finish entirely in June), while also upwardly revising its inflation projections by a significant amount.
These moves signal a fact we correctly predicted, namely that central banks will remain relatively hawkish in spite of the war in Ukraine, being more concerned about the inflationary impact of the conflict than its potential negative impact on economic activity. The Bank of Japan, among the “Big 4” central banks, remains however an outlier here, having left its policy stance unchanged in March. But this can be explained by the still-low rate of inflation in Japan, following three decades of deflation/lowflation.
In our column we also argued that governments will need to do their part in supporting economic activity wile central banks focus on combating rampant inflation and preventing the de-anchoring of inflation expectations. A simple solution would be for governments to partly offset the rise in energy prices (gas and oil) by reducing the taxes on final energy products, such as petrol at the gas station. Some governments have started to do so. In Italy, Mario Draghi has announced a temporary reduction of the fuel duty by EUR 0.25 per litre. In the UK, Chancellor Rishil Sunak is widely expected to adopt a similar measure to reduce the impact on households and businesses in the Spring Budget Statement on Wednesday.
Hence, it seems that a division of labour is emerging between central banks (focusing on inflation) and governments (supporting economic activity). However, it is not so simple as this. Additional fiscal stimulus in this phase may prove inflationary, defeating the purpose of the central banks’ tightening, or at leasing making it more complicated. The example of the fiscal stimulus provided by the US during the pandemic, which is certainly one of the reasons behind the rapid surge of inflation in the country, is illuminating in that respect.
Furthermore, the fiscal stimulus provided during the pandemic was directly or indirectly monetised by central banks, which is not going to be the case in this instance. This may result in higher market rates, i.e. in tighter financial conditions as a result of government intervention, at a time when central banks are already raising policy rates.
All this suggests that although economic policy authorities are moving to do what they perceive to be their job, finding the correct policy mix, let alone the optimal policy mix, may prove elusive.
by Brunello Rosa
14 March 2022
The war in Ukraine is raging, with the latest reports being of the atrocities of the siege of Mariupol and continued deaths among the civilians. Diplomacy is not making much progress, as the meetings between the Russian and the Ukrainian delegations are effectively fruitless. The EU leaders held an informal meeting in Versailles in France, the final declaration of which asked for an immediate ceasefire, with Russian troops withdrawing from Ukrainian territory but without offering Ukraine a fast track to EU membership.
What is clear is that Macron has gained the role of the de-facto head of Europe (to which he has aspired for some time), thanks in part to Germany’s and Italy’s relatively low profile (considering that Germany and Italy have the largest economic ties with Russia among major European countries, and will be the worst hit by the sanctions). In recent days Macron has spoken with Putin more than once, alone or together with German Chancellor Olaf Scholz. But these bilateral interactions have had little impact, apart from clarifying that Russia will not stop its invasion anytime soon, and certainly not before having reached the geo-strategic objectives discussed in our previous columns.
Besides this war on the ground, there is the economic conflict deriving from the sanctions imposed on Russia by a large portion of the international community. Among these, there is the disconnection of a number of Russian banks from the SWIFT massaging system for international payments. The SWIFT circuit is based in Brussels (EU) but is commonly perceived to be dominated by the US. We warned about the risks associated with this move even before Russia launched the attack on Ukraine on February 24th, when it was considered only an extrema ratio. Now that it has occurred, we reiterate our concerns.
To begin with, China has already offered Russia use of its alternative payment system for international transactions, called CIPS (acronym for Cross-boarder International Payment System), which the country has developed over time and is used mostly in South-East Asia. Clearly CIPS is not as widely used as SWIFT, considering that China itself has partnered with SWIFT for the further development of its CBDC project, alongside CIPS. However, its importance is growing over time, and the acquisition of Russia among its users could provide an unexpected boost to its adoption, and accelerate the process of it becoming utilised more widely.
Secondly, during the past few years the crypto-asset industry has created a system for international transactions that is completely alternative to the traditional circuits. Admittedly, crypto-assets, the most famous of which is Bitcoin, have ceased to be considered a viable and efficient system for international transactions when it became clear that traditional circuits, such as those provided by credit cards, could provide faster, cheaper and more environmentally friendly transactions. However, they may still be used to evade the implementation of sanctions, as recently warned by UK financial regulatory authorities and be used as an alternative channel to traditional payment systems.
Additionally, evidence is emerging that while banks are implementing the sanctions even beyond the letter, crypto exchanges are limiting themselves to adopting only the bear minimum measures to be sanctions compliant, presumably in an attempt to gain ground from this period of crisis of international payment systems.
These two phenomena combined may eventually lead to the total polarisation of the international payment system, with the US and its allies continuing to use SWIFT and the traditional circuits (including the use of emerging “stable-coins”), while China and its allies, including potentially Russia, adopt alternative systems such as CIPS, or those deriving from digital assets such as CBDCs and crypto-assets. This bifurcation of the payment system could mirror the balkanisation of international relations and global supply and value chains of the physical, non-digital world, thus further accelerating the ongoing de-globalisation process.
by Brunello Rosa
7 March 2022
The war is raging in Ukraine. The Russian army is attacking the country from all fronts, focusing its recent efforts on the coastal cities of Mariupol and, possibly, Odessa. Meanwhile the capital Kiev is under siege, with 60 km of tanks having reportedly been deployed to the city for this mission alone.
In recent conversations with foreign leaders such as French president Emmanuel Macron and Israeli PM Naftali Bennet, Russia’s president Vladimir Putin has directly or indirectly declared his intentions as being the takeover of the whole of Ukraine. This may be one way of achieving the goal of splitting the country into two parts, as we discussed in last week’s column, even as negotiations continue intermittently between the two sides.
While these negotiations are unconvincingly carried out by the two delegations, Putin’s army continues to tighten its grip on the country by escalating the nature of its targets, which recently included some of the Ukrainian nuclear power plants.
Western countries are responding to this military escalation with an increasing set of economic sanctions, which now include seizing the assets of various oligarchs around the world, banning selected Russian banks from using the SWIFT messaging system, and forbidding exports by large manufacturers (including computer chip and car makers) to Russia. At the same time, energy prices have soared, with Brent crude oil prices having reached $118 per barrel.
As we discussed in our recent in-depth analysis, the economic impact of the war and the related economic sanctions is likely to be akin to a stagflationary negative supply-side shock, resulting in slower economic activity and higher prices.
How are central banks going to respond to such a shock? Central banks had been in the process of beginning to normalise their policy stances just before the war began. Some commentators thought that the economic impact of the war would induce them to take a less hawkish attitude towards their policy normalisation programs. However, the current shock has made the policy dilemma they had already been facing before the war even more acute.
The way central bankers will likely deal with these contradicting inputs from the real economy is by considering whether slower growth or higher inflation poses a more immediate and larger threat to their policy objectives.
As far as growth is concerned, even assuming that the economic impact of the war and related sanctions will shave off some tenths of percentage points (or potentially full percentage points) from the growth rate expected by the largest economies in 2021, this is unlikely to be enough to push these economies into recession this year, as they are still enjoying the benefits of the rebound in GDP growth following the 2020 pandemic-related collapse. By contrast, the impact on inflation is likely to be larger and more immediate, given the increase in energy prices and the further disruption in global value and supply chains.
As such, central banks are unlikely to deviate massively from their intentions declared just before the war, and are instead likely to press on with their policy normalisation plans in coming months. Certainly they will continue to assess the situation regularly and will react accordingly, with the war likely to cause at least a slight deceleration in their planned tightening of their policy stance.
As such, those who expect central banks to wildly revisit their policy intentions are likely to be disappointed in coming weeks.
This images is taken from this website
by Brunello Rosa
28 February 2022
In spite of all of the intelligence provided by the US and UK security services, which warned about Russian President Putin’s belligerent plans, the world was shocked by last week’s images showing Russian tanks crossing the borders of Ukraine and beginning a full-scale invasion of the country. In the days preceding the invasion, we had assigned a probability of 25% to an immediate de-escalation taking place, with the remaining 75% divided between a 55% chance of there being a controlled escalation and a 20% probability of a full-blown invasion.
Though the escalation has been ratcheted up gradually, we were also surprised by the intensity of the attack. The decision by the Russian army to directly target the capital Kiev suggests that we are clearly in an open conflict aimed at a full-scale invasion.
We could discuss how we got to this situation. Russia annexed Crimea in 2014, so eight years have passed without the West being able to offer a possible solution to a crisis that was clearly brewing, while Putin had all the time in the world to carefully plan his country’s actions (starting from the constitutional change that will allow him to stay in power potentially until 2036). At this stage, however, we believe it is more relevant to discuss what a possible endgame could look like, and what the wider implications of the invasion might be.
From a geopolitical perspective, Russia is likely to have the upper hand here. NATO cannot intervene in defense of a non-member state, and even if it decided to do so, what would it do? Bomb Ukrainian cities? Attack the Russian army? Both options seem unfeasible, for easily understandable reasons. Other possible retaliatory strategic measures (such as including Finland in NATO, annexing Kaliningrad’s enclave, aiming at a regime change in Russia, re-integrating Moldova into Romania, or similar) all seem totally out of reach, unless one wanted to entertain the idea that WW3 is an immediate possibility (as President Biden put it). Hence this is, and will remain, an asymmetric war.
This asymmetric war in which Russia can use tanks and the West only sanctions means that Putin will soon control the entire Ukrainian territory. At that point, it will be able to negotiate from a position of strength. We do not think it will proceed to an annexation of the entire Ukrainian territory to Russia: this would defeat the purpose of the invasion, i.e. preventing Russia from sharing a large border with NATO countries (such as Poland, Hungary, Romania and Slovakia). It is more likely that Russia will proceed with an annexation of the Russian-speaking regions of Ukraine (the central-east and south-east regions of the country – see map above). In the west and the centre of the country Putin may want to install a puppet government which will guarantee that what is left of Ukraine will never join the EU or NATO.
If this plan succeeds, Russia will have gained total control of the Azov sea. It will have achieved, among other things, a full continuity of navigation between the Caspian Sea and the Mediterranean Sea, via the Black Sea, by way of the navigable Don and the Volga rivers and the Volga-Don Canal. For this reason, Turkey decided to ban access to Russian military ships via the Turkish straits, which link the Mediterranean to the Black Sea. More importantly, however, Russia will have secured the so-called “geopolitical depth” it is looking for, with a series of “buffer states” between NATO and the Russian motherland: Belarus, (the remnants of) Ukraine, Georgia, Armenia and Azerbaijan. The recent advances made in Kazakhstan will have also secured the southern front, toward the borders with China.
In future columns and pieces of research, we will also discuss the macroeconomic and financial implications of this war, which have been recently discussed in an article by Nouriel Roubini. Roubini highlighted how this war will impose another stagflationary shock on the global economy, making it even harder for central banks to respond to the slowdown in economic activity and rise in inflation that has been taking place in the last few months.
by Brunello Rosa
21 February 2022
This week will be the second of three consecutive weeks of industrial actions involving university personnel over the issues of pension cuts, salaries, and working conditions. The trade union Unison explained that the offer of a 1.5% pay rise (which would be significantly below the current inflation rate) is not enough to compensate for the increased workload of teachers and university personnel that occurred during the pandemic.
Meanwhile, British Airbus workers have also decided to go on strike over “unacceptably low” pay offers they received from the company. These are only two recent examples of industrial action (aka strikes) undertaken by workers and trade unions in several public and private sector organisations.
This phenomenon is not limited to the UK. In the US, the month of October was characterised by several industrial actions within large corporations (such as Kellogg), which led to the nickname “striketober”. October was the peak of an increasing chain of strikes that took place throughout 2021. This is set to continue in 2022, when a number of large contracts will be up for renewal in several sectors.
In absolute terms, the number of actions and the number of cumulative working days lost are still tiny compared to the hot decades of the 1970s and 1980s. Just to give an example: in the UK, in January 1979 there were 3 million working days lost to strikes. In January 2018 there were only 9,000 working days lost to strikes.
Still, the pandemic has certainly marked a turning point. The first phenomenon to emerge was that of the so-called Great Resignation, when thousands of people around the globe voluntarily left their jobs in search of better opportunities, higher salaries, more decent working conditions, and perhaps also in protest of what was perceived to be the worker “exploitation” their companies engaged in during the pandemic (for example, when working from home became the excuse for companies pressuring their employees into seemingly endless working days and weeks).
After that, labour shortages and sharp increases in living costs have done the rest: workers who kept their jobs are fighting for better working conditions in terms of working hours and pay, as inflation is clearly eroding the real value of their salaries.
In more general terms, workers are fighting for a more equal distribution of income between labour and capital, following decades in which the labour share of income in the economy has diminished in favour of rents, interest and profits. Trade unions, the power and representativeness of which collapsed with the rise of neo-liberal economics and supply-side policies in the 1980s and 1990s, are regaining power.
What could be the risks of these shifts, going forward? While a more equal distribution between labour and capital is certainly desirable, in this period of high inflation that is taking place in part due to supply bottlenecks, further disruptions in value chains due to industrial actions may cause an additional increase in prices, making even this short-term inflation more persistent than it is already proving to be.
Furthermore, if wage increases are asked to compensate for higher costs of living, the infamous wage-price spiral that characterised the “dark ages” (in terms of industrial relations) of the 1970s and 1980s may return. Especially if mechanisms of automatic indexation of wages and pensions were to return (which hopefully they will not). A new wage-price spiral could lead to a sustained increase in unit labour costs (this occurs when wages increase faster than productivity), which is the engine of domestically-generated inflation – the type of inflation that is more difficult to eradicate.
In order to avoid these risks, moderation and common sense need to be exerted by all parties involved.
by Brunello Rosa
14 February 2022
Tensions at the border between Russia and Ukraine have reached a point of almost no return during the past few days. As we discussed in an in-depth analysis by John Hulsman, Russia has amassed at least 125,000 troops in the areas neighbouring Ukraine. Last week, Russia and Belarus began a 10-day joint combat training exercise, which reinforces the impression that Russia is ganging up with its satellite states to prepare an internationally coordinated invasion of Ukraine. A large swathe of countries, including the US, have ordered their own diplomatic forces and citizens to leave Ukraine.
Most importantly, diplomatic efforts have intensified in the last few days in an attempt to dissuade Russian President Putin from invading Ukraine. French President Emmanuel Macron flew to Moscow and agreed with Putin that they “share security concerns” in Eastern Europe. US President Biden has recently spoken to Putin and warned that the US will react forcefully to a possible Russian invasion of Ukraine, a concept that will be repeated tomorrow by German Chancellor Scholz, when he will travel to Kyiv and Moscow.
Tensions between Russia and Ukraine are not new of course. Recently they reached a peak in 2014, when Russia annexed Crimea, following months of destabilisation of the Russian-speaking regions in east Ukraine (Donbass in particular). Eventually, the Minsk Protocol and the Minsk II agreement (consisting of 12 points, including an immediate ceasefire) emerged to at least freeze the situation and re-establish diplomatic relations. But progress has been modest. Even the election of Volodymyr Zelens'kyj to the Ukrainian presidency in 2019 has not helped.
The issue on the table remains the same: Russia does not want Ukraine to become part of the various European communities beyond the existing association agreement, let alone a member of NATO. The ideal solution would be Ukraine following the Finnish example, of remaining a neutral country (i.e. not becoming NATO member), even as Finland has become over time a member of the EU and even the Eurozone.
But Russia does not trust the word of the West since 2004, when the Baltic republics, once part of the Soviet Union, joined NATO, leaving the Russian border directly exposed to NATO member countries in spite of all the reassurances provided to Russia that this would never happen. Since then, Russia has tried to re-gain the “geopolitical” depth that has always allowed Russia to prevent a foreign invasion.
The possibility of avoiding an open conflict still exists, but it is diminishing by the hour. The West is trying to use both sticks and carrots with Putin to change his calculus and lessen the attractiveness of an invasion, given the potential consequences that such an invasion might entail. But there is something the West would be ill-prepared for: the possibility of an asymmetric or covert act of war, such a domestic putsch in Ukraine or a large-scale cyber attack on key infrastructure.
How would the West respond to attacks that only supposedly can be attributed to Russia, attacks that could be covered by the usual “plausible deniability” disclaimer? Ukraine is reportedly shoring up its cyber defences against a possible attack of this kind, given that Russia is the leading country in the world in terms of cyberwarfare capabilities. After all, one of the most famous cyber attacks in recent history, the infamous Petya/NotPetya malware, which paralysed large multinational companies such as the shipping and logistic giant Maersk, originated from Russian attempts to destabilise the Ukrainian cyberspace.
One way or another, tensions between Russia and Ukraine are unlikely to settle soon. Policymakers, market participants and populations at large would be better to prepare for the worst to happen.
by Brunello Rosa
7 February 2022
The 1970s were characterised by structurally high inflation. A number of events contributed to that environment. In 1971, US President Richard Nixon announced the end of the USD convertibility into gold, causing the collapse of the Bretton Woods agreements between 1971 and 1973. This meant the end of the fixed-exchange regimes that had regulated the international financial environment since the end of WWII.
Central banks had to switch their “nominal anchor” from the exchange rate to the inflation rate, and they were unprepared to do so. The two oil shocksof 1973 (following the Yom Kippur war) and 1979 (following the Iranian revolution) meanwhile contributed to global inflation rates reaching double-digit territory. And the indexation mechanisms of salaries and pensions induced a price-wage spiral, which underpinned the high inflation rates of that decade and of the 1980s.
Gradually, during the 1980s and 1990s, central banks gained operational independence from their government, to set interest rates, and by the end of the 1990s were able to reign in inflation. Meanwhile, globalisation, which also started in the 1970s with Nixon's trip to China in 1972 and the opening up of the Chinese economy to capitalism under Deng Xiaoping, also induced a rapid deflation in the price of manufactured and technological goods. Overall, one may consider the period between 1985 and 2020 as the “great dis-inflation” era, with inflation rates well below the established targets for the past 10 years or so, during which time central banks have been struggling to make inflation return to target.
The 2020-22 pandemic has radically changed this dynamic. Supply bottlenecks, high energy prices, labour shortages following “the great resignation” phenomenon have induced a short-term increase that has clearly caught global central banks by surprise. They thought these phenomena would be “temporary”, “transitory”, or “transient”, but have instead had to realise that inflation deriving from such a large negative supply shock and positive fiscal stimulus has proved to be higher and more persistent than they had initially anticipated.
As we discussed in previous columns, even once this short-term inflation has subsided, a more persistent inflationary environment will emerge as a result of the technological and ecological transition the world is now going through, as well as a result of the more equal distribution of income between capital and labour that is about to happen and is badly needed, and the balkanisation of global supply chains deriving from incipient de-globalisation. After the inflationary era of 1970-1985 and the deflationary era of 1985-2020, a new inflation era is about to start.
Central banks are getting ready for this new inflation era. In the last few weeks, the world’s major central banks have clearly changed tack. The Fed confirmed that QE tapering will end in March and that the first rate increase will also occur in March, opening the road to four if not five rate hikes in 2022. The Bank of England increased its policy rate on back-to-back occasions after its December hike, for the first time since 2004, and almost half of the Policy Committee wanted a 50bps increase instead of the standard 25bps that was in fact adopted.
Finally, the ECB also hinted at an imminent policy shift that is likely to materialise in March, when the new staff macroeconomic projections will be released. Of the four major central banks, only the Bank of Japan so far has remained in the old era of the deflationary environment – but this is because inflation rates remain close to zero in Japan. For now.
by Brunello Rosa
31 January 2022
Sergio Mattarella was re-elected Italy’s President of the Republic on Saturday, after seven inconclusive ballots. Nervousness had been mounting in political circles, as well as in the country at large, for the inability of the electoral college (made up of MPs and regional representatives) to converge on a figure who would be able to win at least 505 out of the 1009 “grand electors”. The political leaders of the parliamentary majority that supports Draghi’s government decided in the end to converge on Mattarella, the only name that would find unanimous support (with the exception, perhaps, of Fratelli d’Italia).
This is the most reassuring outcome that one could hope for in the short run, as it guarantees total institutional and governmental continuity. Mattarella is well-respected internationally and is able to guarantee Italy’s position within the geopolitical landscape. Draghi, moreover, will remain PM, guaranteeing the implementation of the country’s recovery plan, which gives access to the funds of the NextGenEU. For these reasons, this political solution is by far the most favoured by market participants (as we discussed in this interview).
On the other hand, Mattarella’s re-election only postpones the resolution of the uncertainty about Italy’s medium-term institutional setting by a couple of years, pushing it back to after the election of the country’s next parliament in 2023. In fact, Mattarella will likely resign as soon as he perceives that a majority can be found in the new parliament to elect his successor, possibly in early 2024.
Draghi will also start encountering difficulties as PM, as political parties will likely be less willing to accept his decisions in the year ahead of the general election. Furthermore, the fact that the political parties that support his government could not agree on his name to become the next president, even after four or five inconclusive ballots, reveals that they do not want to give him carte blanche on every issue.
Additionally, if one needed further proof of the inability of Italy’s political system to achieve even the most basic goals, this election showed that parties cannot even discharge their duty of electing Italy’s top institutional figure. The complaints that political leaders often make about being subject to the rule of technocrats are therefore totally mis-placed. They had the chance of showing effectiveness in their actions, and failed miserably. But this is hardly a surprise.
If we look at the broader European political landscape, we said that 2021-22 was the crucial period to test the resilience of the European construct. If any of the German general election, Italian Presidential election and French Presidential and parliamentary elections were to “go wrong”, the survival of the European project itself would be at risk. German elections have delivered a very fragmented parliament, but a “traffic light” majority, however heterogeneous and weak, ultimately emerged. Italy kicked the can down the road. Now it is France’s turn.
In France, Macron is still ahead in the polls and may be re-elected, but the emergence of Valérie Pécresse as leader of the Republicans will make the June parliamentary elections more uncertain, with Macron possibly forced to his first co-habitation. In any case, both Macron and Pécresse are mainstream politicians and would keep France on track with the European integration process. A different story would be if Eric Zammour or Marine Le Pen were to prevail, though this outcome remains only a risk scenario at this stage.
Two out of three electoral risks have not materialised so far, and the third – France’s – is unlikely to. This bodes well for the continuation of the EU integration process. But EU leaders need to remain alert, as populist parties are still strong in many countries of the Union, including in France and Italy.
by Brunello Rosa
24 January 2022
The process to elect the next Italian president begins this week. The president is elected by an electoral college composed of 1008 “grand electors”, made up of current MPs (deputies and senators) as well as 58 regional representatives. A super-majority of 2/3rd of votes is necessary for a president to be selected in the first three rounds of voting. From the fourth round onward a simple majority of 505 votes will be sufficient.
There are a lot of misconceptions regarding the role of the president in Italy. Most people believe it is only a ceremonial position, carrying little weight in the actual decision-making political process of the country. This may be true in relatively tranquil times, in which political parties have full control of parliament and the government in general. But in turbulent times, when a political crisis emerges, the president is akin to the “reset button” of the system. The president appoints the PM and, by way of the PM’s suggestion, all the ministers as well. The president can also dissolve parliament, calling early elections. Other powers at the president’s discretion include the possibility of vetoing a law before it is promulgated (though he or she can do so only once), as well as being the formal commander in chief of the military. The president also presides as the governing body of the judiciary.
As we have previously discussed, the next Italian parliament will be reduced in size relative to the current parliament, a result of the referendum which cut the number of MPs by almost half. The next parliament will also be a balkanized one, given the fragmentation of the political system and the reduced electoral size of the major parties (the four largest parties each poll between 16% and 21%). In such a situation, we know that the next president will almost inevitably be the “deus ex machina” of the political system.
So, who will be chosen by the parties to be “commanded” for the next seven years? The parties may opt for a second-tier political figure, as has happened in the past. Such a pick would be less likely to disturb their political manoeuvring, after all. At the same time, the proven inability of parties to provide viable political solutions in the past suggests that political leaders may be wise to choose somebody of a higher calibre, somebody who can actually resolve possible future crises constructively.
At the same time there is the need for Italy to have a very competent PM who is able to implement the recovery plan, which will allow Italy to receive around EUR 50bn in the next few months as part of the NextGenEU plan.
Both of these requirements point to the figure of Mario Draghi, who is certainly an extremely competent PM and would be an equally good president. Already in 2020 we discussed the pros and cons of having Draghi at Palazzo Chigi (as PM) or at Quirinale palace (as President). At that time, Draghi was nowhere near entering Italy’s political system.
More recently, we said that Draghi would be able to better exert his influence on the system as president, while most commentators thought he should remain PM. More recently, there seems to have been a conversion on the road to Damascus moment: all of the most influential press is pushing for Draghi to become president and thereby hope to ensure seven uninterrupted years of institutional stability. Most recently the FT joined this group calling for Draghi to become president, in an unsigned editorial.
We still consider Draghi at Quirinale a far better option than at Chigi, especially if the government remains similar to the current one, and if its parliamentary majority remains intact. But we know from experience that the election of the president is a roulette. Even much more powerful first-tier political leaders of the so-called First Republic (1948-1994) did not manage to ascend to the Quirinale. If Draghi does not make it, then, perhaps an institutional figure from the centre -right (Marcello Pera, Elisabetta Casellati, Gianni Letta, etc.) may emerge instead, or else perhaps a relatively independent institutional figure will emerge (such as the former president of the Chamber Pierferdinando Casini. The centre-left however does not seem to stand a chance to elect its president this time around, even if it could put forward credible candidates such as Romano Prodi or Paolo Gentiloni.
by Brunello Rosa
17 January 2022
When the Covid-19 pandemic began, many countries had been in the process of unwinding some of the extraordinary measures they had introduced years before to counter the effects of the global financial crisis and the ensuing Great Recession of 2007-2009. Central banks had taken the lead in the policy response to the crises of 2007-2009, as some governments, especially in Europe, had mistakenly reacted with a mix of fiscal austerity and structural reforms, policies which deepened a recession which was eminently being driven by the (lack of) demand side of the macroeconomic equation.
Central banks meanwhile introduced ultra-long term repo operations (extended to 3-4 years maturity) against wider collateral, large-scale asset purchases (LSAPs), credit-easing facilities, forward guidance on rates and asset purchases, and negative policy rates. This arsenal was deployed in various forms and at various points in time throughout the 2010s. Some governments admittedly introduced forms of fiscal support, and certainly they indemnified central banks (whether directly or indirectly) for taking additional risks on their balance sheets, especially credit and liquidity risks, together with a massive increase in reputational risk. But both central banks and governments were keen to emphasise how these decisions were taken independently of one another, so as not to compromise their respective areas of autonomy and independence.
In early 2020 most central banks had been in the process of winding down the policies created ten years before, but then had to quickly reverse their course of action in order to respond to the pandemic. Central banks had to re-implement those measures they had been unwinding, to some extent on an even larger scale than had been the case pre-pandemic. This time around however governments realised that they too needed to react with large fiscal stimuli, causing fiscal deficits to reach double digit figures in many countries.
In this case, the policy response was “coordinated” with central banks, which were asked to directly or indirectly monetise these large deficits. Investors praised this monetary-fiscal coordination, which represented the main policy innovation of this crisis.
As the economy normalises, and as central banks start focusing on inflation developments more than on supporting economic activity, it seems that this coordination with fiscal authorities is becoming less pronounced. Central banks are re-focusing their policy actions toward fighting inflation, after decades of dis-inflation and of inflation targets undershooting and the fear that if central banks continue to provide a backstop to the bonds of highly indebted countries, it may eventually lead to some form of “fiscal dominance.”
But this may hardly prove to be the case in the short run.
Governments extended large amounts of fiscal support to their populations knowing, or assuming, that central banks would effectively monetise the debts they incurred to do so – this prevented debt-issuing and debt-financing costs from spiralling out of control. Policy and short-term and long-term market rates actually fell to new lows during this period. But things seem to have changed recently. As central banks announced the end of their extraordinary measures, market rates increased, as the banks’ moves were not announced in coordination with their respective governments.
In fact, central banks seem to fear that, if they continue coordinating with governments, they will become subject to some form of “fiscal dominance,” de-facto losing their independence. While the risk exists that central banks will eventually fall back within the sphere of influence of their respective Treasuries over the medium term, in the short term coordinating with their governments to exit from the policies they implemented in the last few years would simply be common sense. In fighting inflation central banks will necessarily exhibit independent decision-making processes. Ensuring that the cost of borrowing for governments remains tolerable in the short term will not endanger central bank independence.
by Brunello Rosa
10 January 2022
The first week of trading in 2022 delivered a very bumpy start to markets. Major equity indices recorded heavy losses during the week (especially the US NASDAQ), and only some European indices managed to close the week in slightly positive territory. There are multiple reasons behind this bumpy start.
First, it is still unknown what the impact of Omicron on economic activity will be. Data suggest that the variant seems less deadly than Delta, but much more transmissible. As a result, the absolute number of hospitalisations is expected to increase significantly (even if the rate of hospitalisation – of mortality – is lower than that caused by Delta). This is forcing many countries to adopt restrictive measures that may have an impact on economic activity in Q1. PMI numbers seem to have peaked in most advanced economies, and are beginning to signal a slowdown in growth. Investors remain puzzled and on the fence regarding the ultimate impact of Omicron and the reimposition of restrictions it is causing.
Second, inflation continues to bite. In the Eurozone, inflation has now reached 5%, and may increase further. In the US, CPI is expected to reach 7% this week and core CPI 5.4%, the highest readings in decades. We have made a distinction between short-term and long-term inflation, which to us is much more significant than that between “transitory” and “permanent” inflation. We think that short-term inflation has yet to peak in many countries, after which it may finally start falling towards the central banks’ target levels during the second half of this year (since China’s PPI seems to have peaked at the end of last year). But long-term inflation, which includes energy and tech transitions, will be the theme to watch for in coming years.
Third, central banks continue to be hawkish. Last week, the minutes of the Fed’s meeting in December showed that the US central bank may be prepared to start increasing rates in March, and could start reducing the size of its balance sheet soon after its initial rate increases. This would be a much more aggressive stance than is currently expected. Jay Powell’s and Lael Brainard’s confirmation hearing in the US Senate this week will shed more light on the current FOMC thinking.
Equally, ECB President Christine Lagarde’s remarks at the Bundesbank’s change of office this week may provide more insights as to the ECB’s views on inflation.
Fourth, oil prices continue to rise. Even in the first week of the year Brent prices rose by 3.6%, to $81.8pb. As President Lagarde said in December, two-thirds of the recent rise in inflation was due to increases in energy prices. So as long as energy prices continue to increase, headline inflation will continue to rise. The upcoming meeting of OPEC+ may reduce some tensions in oil markets, if the group agrees on an increase in production, but there may be geopolitical obstacles that prevent such an agreement.
Finally, geopolitical tensions persist in countries that have a large impact on commodity prices, including Russia, Ukraine and Kazakhstan. The situation at the eastern border of Ukraine remains extremely tense, with Russian troops possibly ready for an invasion. Upcoming US-Russia talks in Geneva (where the EU would like to be involved) may provide some short-term relief, but the situation will remain problematic for years to come. Meanwhile, Kazakhstan seems on the verge of a regime change, perhaps through a coup. Clearly the former Soviet republic has now entered the Russian radar screen. Kazakhstan is a major oil producer, but also a major centre of crypto-mining, hence the recent collapse in Bitcoin, Ethereum and other crypto-asset prices.
All these factors, and in particular the rise in inflation and oil prices, and the hawkish reaction by central banks, have caused a sizeable increase in short- and long-term interest rates in the US and the Eurozone. In the US, the 10y Treasury yield has reached 1.75%, and in the Eurozone, the 10y bund yield is now almost back into positive territory.
Clearly a combination of higher inflation and market yields is severely detrimental for most asset valuations, including bonds, equities, real estate, and risky assets such as tech stocks (which have suffered their worst week in more than a year). Unfortunately, those factors most likely will remain in place for most of 2022. And for this reason, 2022 is likely to be a much more volatile year in markets than 2021 was, as was recently discussed by Nouriel Roubini.
by Brunello Rosa
4 January 2022
With 2022 upon us, it is worth discussing the key themes to watch during the early part of the year. New themes emerge will doubtless occur as the year progresses and events unfold, but for now, here are some of the issues we are keeping a close eye on.
The Pandemic – The Beginning of The End? With the arrival of the Omicron variant, 2022 is unfortunately beginning in the same way that 2021 did with the Delta variant. By February/March 2022 we will have marked two full years of pandemic, and at least four waves of it. It is confirmed that Omicron is much more transmissible than all other strains, as proven by the spike in infections observed around the globe. But its hospitalisation and mortality rates are not worse than its predecessors, thanks in part to the diffusion of vaccines, especially for those who received their third, “booster” dose. This means that it is possible that Omicron represents the lucky mutation we are all looking for: a very transmissible but not very serious virus, which renders Covid akin to a severe flu, rather than a deadly disease. The first few months of the year will clarify whether this is the case or not.
Inflation – The Monster Is Raising Its Ugly Head Again. There will be plenty of inflation data coming out this week, especially from Europe, where CPI reached nearly 5% recently. Coupled with the (nearly) 7% figure reached in the US, this means that large parts of the developed world have now been experiencing rates of inflation unseen during the past few decades. This short-term inflation, due to supply bottlenecks, base effects, and the reopening of economies, may be coming to an end (Omicron permitting) and in the meantime central banks have also been very alert to it. We remain more concerned about medium-term inflation, influence by the balkanisation of global supply chains, a more equitable distribution of income between labour and capital (including an increase in minimum wages) and the cost of ecological and related technological transitions.
All these factors may result in a one-off price-level adjustment (in a positive scenario) or in persistently higher inflation rates (in a less favourable scenario).
Central Banks – Barking and Biting? Central banks have certainly turned more hawkish in December as a result of recent inflation outturns, in what we believe is an under-appreciation of the economic impact of the new restrictions imposed by governments as a result of Omicron’s emergence. Some of them have already started to “bite”, with interest rate increases (such as the BOE, Norges Bank, RBNZ and many EM central banks), or by accelerating the process of tapering asset purchases (such as the US Fed). Others, such as the ECB, have only “barked” so far, and it will take time for their words to be followed by action. But we are certainly entering a phase in which central banks will give priority to fighting inflation rather than supporting economic activity.
The Italian Presidential Election. Italy will elect its new president at the end of January. As discussed several times, this could fundamentally change the equilibria that exist within Europe, if a EU-sceptical president is elected to succeed Mattarella. Draghi remains the key candidate, but if he goes to Quirinale palace, a new government must be formed, and that could result in renewed political instability.
The Risk of A Russian Invasion of Ukraine Persists. Russia has massed troops at the border with Ukraine, threatening an invasion if Ukraine makes further moves to approach Western alliances such as the EU and NATO. The US has reacted by saying that an invasion will result in a very serious response. What Russia wants is Ukraine becoming like Finland, i.e. neutral. But mistakes may be made by both sides, threatening to cause an unwanted escalation.
by Brunello Rosa
27 December 2021
In the last few years, government bonds have been some of the most successful asset class available to investors, together with equities. In response to the dot.com bubble in early 2000s, central banks have brought their policy rates down to zero and in response to the Global Financial Crisis of 2008-09 they have started to conduct large scale asset purchases (LSAPs), in what has been called “Quantitative Easing” (Q.E.). All these policies, together with forward guidance, have brought market rates to historically low levels, in some cases in negative territory in important jurisdictions such as the Eurozone and Japan.
But the beginning of the secular bull market in sovereign (and, by extension, corporate) bonds dates back to the 1980s. After Paul Volcker rose the Federal Reserve’s policy rates into double digit territory to defeat the persistent inflation originating from the two oil shocks of the 1970s and the rupture of the Bretton Woods agreement, the subsequent secular fall of policy and market rates has originated a bull market that is still persisting today, almost half a century later.
But in 2021, inflation has raised its ugly head after many years, as a result of the pandemic. Bottlenecks in global supply chains, base effects, higher energy prices, the re-opening of the economy have all led to a rise in inflation around the globe, especially in the US, where it has reached almost 7% y/y, and in the Eurozone, where it is already above 5% y/y. As a result of all this, central banks have reacted by turning hawkish, as discussed in several columns recently.
This volte face has surprised the market, and there is the possibility that central banks will tighten their policy stance more quickly than currently anticipated. Several central banks, in both DMs and EMs have already increased their policy rates in the last few weeks.
As a result of all this, sovereign and corporate bonds have severely underperformed recently. According to a recent article by the Financial Times, “the Barclays global aggregate bond index — a broad benchmark of $68tn of sovereign and corporate debt — has delivered a negative return of 4.8 per cent so far in 2021.” This negative performance could spill into 2022 if inflation proves to be more persistent and central banks prove to be more proactive in trying to tame inflation than currently expected.
Other asset classes sensitive to inflation and higher yields, such as equities and real estate, may suffer as well, but the greatest impact would be felt by sovereign and corporate bonds. Having said all this, this may still not be the end of the story. As discussed last week, central banks don’t seem to have factored in enough the impact that Omicron (and the restrictions related to the variant) will have on economic activity. The combination of new restrictions and tighter monetary policy may result in such a dramatic halt in economic activity that inflation will eventually fade, and central banks may need to undo some of the policy tightening introduced so far. This may lead to a renewed phase of bullishness in bond market in the earlier part of 2022.
In conclusion, while the prospects for bond markets don’t see particularly rosy at this stage, we think it’s still a bit too early to write off this asset class in 2022 just yet.
by Brunello Rosa
20 December 2021
Two sets of events took place last week. The first was that governments started to move much more resolutely against the spread of the Omicron variant across the globe. New restrictions began being re-imposed by several countries. The Netherlands imposed a form of lockdown; Ireland re-introduced a curfew; a number of countries, including the UK and Italy, are thinking about introducing additional restrictions after Christmas. The “Rule of 6”, or similar limitations on the number of people that can meet at the same time may be re-introduced by several countries.
International travel has been actively discouraged, meanwhile. In Austria, people can enter the country only if they have received a third dose of vaccine. France banned non-essential travel from the UK. A number of countries, including Italy and the UK, have re-introduced pre-departure tests for incoming travellers.
These new restrictions are likely to have a significant economic impact, as did the restrictions introduced in previous winters in H1 2020 and in H1 2021. They are likely to reduce economic activity and possibly induce a further increase in inflation. Although the restrictions’ impact on prices is likely to be ambiguous at the beginning, and the reduction in economic activity they cause may imply a moderation in prices, they may also cause supply bottlenecks to persist for longer, and this may induce a further increase in prices.
Thus far, governments have not considered introducing financial compensation for companies and workers that may be forced to close or work less as a result of Omicron’s spread.
To some extent, therefore, the task of providing policy accommodation remains with central banks. Central banks however now seem to worry mainly about inflation, and much less about the potential impact of Omicron on economic activity.
Indeed, the second set of events that took place last week was that the policy committees of a number of G10 central banks, and also EM central banks, met, and nearly all of them opted for a less accommodative policy stance.
As we discussed in our in-depth analysis, virtually all central banks became more hawkish and announced a variety of reductions to the policy accommodation they have so far provided during the pandemic. The Fed announced a faster pace of QE tapering and a speedier policy normalisation path. The ECB announced a severe reduction in net asset purchases starting in March 2022. The Bank of England and Norges Bank actually increased their policy rates, as did the central banks of Chile and Russia. And the BoJ partially reduced the level of stimulus it has been providing until now.
These tightening measures are meant to counteract the rise in inflation that has been observed globally during the past few months. But they also risk doing harm to an economy that is already being hit by the new wave of the pandemic. So, unless governments introduce some form of compensation for companies and individuals, central banks may need to revisit their tightening plans in coming months.
Through all of this, markets are remaining volatile, being buffeted by the news of the pandemic and the uncoordinated policy response to it that is now taking place.
by Brunello Rosa
13 December 2021
The Omicron Covid variant continues to make the headlines as it spreads around the globe. New cases are being registered in every continent, and they seem to confirm that this new variant is more contagious than the Delta variant. It is yet unclear whether Omicron causes more severe symptoms than previous variants, but preliminary evidence seems to suggest that it does not.
The biggest question though is whether or not the vaccines that have been administered to large swathes of the world population will remain effective against Omicron. In this regard, the evidence is mixed. The CEO of Moderna, one of the providers of the mRNA vaccines, suggested that its vaccine was effective, only to say a day later that this suggestion may have been false, and that a new version of the vaccines need to be developed in order to counter the Omicron variant. On the other hand, Pfizer-Biontech has been more constructive, saying that three doses of their vaccine are enough to provide protection against the Omicron variant. Pfizer-Biontech also confirmed that a new version of their vaccine, specifically tailored to Omicron, will become available in March 2022. One may notice the slight inconsistency here. If three doses of the old vaccine are effective, why do we need a new one?
At any rate, it seems we are back to square one: the race between new variants and mankind’s ability to develop new vaccines is still ongoing. As vaccine development takes time, governments are resorting to the usual methods, reintroducing various forms of restrictions in Europe especially (in Germany, the Netherlands, Austria, Belgium and, to a lesser extent, Italy and France), including social distancing, quarantining after international travel, obligatory wearing of face masks, working from home policies, partial or total lockdowns for entire populations or for unvaccinated people only. Even in the UK, where for months PM Johnson has resisted the pressure to introduce the so-called plan B, the government had to capitulate and re-introduce a series of restrictions that had been lifted after the “freedom day” of July 19th, 2021.
The economic impact of the introduction of these restrictions is yet to be ascertained, but one can imagine a slowdown in the pace of the recovery resulting from them, and a further increase in prices deriving from yet another negative supply shock. This mild stagflationary situation is the nightmare scenario for central banks, which hate being confronted with the ugly pairing of rising inflation and slowing economic activity. Additionally, central banks are impotent against supply-side shocks, both positive and negative.
After about a month of relative tranquillity, a number of G10 central banks will meet this week. On Wednesday, the Fed will likely announce an increase in the pace of tapering its asset purchases. On Thursday, there will be policy meetings for the ECB, the Bank of England, Norges Bank, the Swiss National Bank. The ECB will likely announce the policy package that will become operational in the post-pandemic emergency, beginning in March 2022. The Bank of England will likely announce that there is still time until February before it will need to raise rates. Norges Bank will likely carry on with its planned 25bps increase in its sight deposit rate, and the Swiss National Bank will likely remain on hold, preferring to intervene in the FX market to stem any excessive appreciation of the Swiss Franc. The Bank of Japan will close the week with a meeting held on Friday, but it is unlikely to announce any major change to its policy stance after the innovations it introduced during the last few months.
Given this background, markets will remain wobbly, with equities see-sawing in response to the news about vaccines. Paradoxically, they may find themselves in a win-win situation. If Omicron proves less deadly than many currently anticipate, equity markets may rally on the prospect of the end of the pandemic finally approaching. If Omicron proves more dangerous than currently expected, central banks may pause their exit from the extraordinary accommodation they have provided in the last couple of years, and instead provide more liquidity to the market and so boost market sentiment. The fly in the ointment in this case remains inflation, which can severely impact the valuation of all asset classes.
by Brunello Rosa
6 December 2021
On Saturday, France’s Republican Party (Les Républicains) chose by way of a primary election its candidate for the presidential race that will take place in April 2022. The winner of the contest was Valérie Pécresse, president of the Île-de-France region since 2015 and former minister for higher education and the budget under Nicolas Sarkozy. She defeated some party heavyweights, such as Michel Barnier, who had been touted as the most credible candidate a serious potential contender against Macron in the general election.
The Republicans are the heirs of the glorious tradition of Gaullist presidents (such as Giscard D’Estaing and Jacques Chirac), but realized their worst ever result in 2017 when their candidate François Fillon was embroiled in an embezzlement scandal which prevented him from reaching the run-off stage of the election against Emmanuel Macron. Given the party’s historical tradition, as we discussed in our recent trip report, we would have not considered the presidential election to have started until the Republican candidate was chosen.
Valérie Pécresse is a moderate centrist within the party, who defeated right wingers such as Eric Ciotti. The party is clearly trying to win back their centrist voters who preferred Macron’s political offer in 2017. At the same time, it is the right flank of the political specturm that Pécresse should guard more closely against. Plenty of competition will come from Marine Le Pen, the leader of the Rassemblement National (formerly the Front National), who reached the run-off round of the election in 2017, and from Eric Zemmour, the former journalist and polemicist who is also running with a radical right-wing agenda, especially regarding immigration.
With current polls suggesting no more than 11% support for her candidacy, Pécresse will have to erode support from the right-wingers if she is to reach the run-off vote against (presumably) Macron. At the same time, her victory in the Republican primary may not make Macron’s life easier. With her modern anti-climate change agenda, Pécresse may also attract some moderate and even progressive voters of Macron’s.
Macron also faces the risk that Marine Le Pen does not reach the second, run-off round of the election. Macron believes that the unwritten “republican pact” that has existed in previous elections, which implies that all non-extremist voters will vote for anyone who is not the representative of the Front/Rassemblement National, will hold once again. But If Le Pen does not reach the second round, this pact may simply no longer apply.
As we discussed in previous analysis, the French presidential and subsequent parliamentary elections, together with the German general election of September 2021 and the Italian presidential election of January/February 2022, will represent the three key elections of the 2021-2022 period, which together may determine the future of Europe. The German election has now resulted in a three-party coalition (unheard of in Germany’s recent history), which still needs to prove its cohesiveness. The Italian presidential election may result in the choice of a strong pro-European president such as Mario Draghi, but could also lead to controversial political figures such as Silvio Berlusconi. The results of these three important votes will determine the shape and speed of the European integration process in coming years.
by Brunello Rosa
6 December 2021
In our column last week, titled “Covid’s Fourth Wave Risks Derailing Europe’s Economic Recovery” we discussed how the fourth wave of the pandemic was hitting Europe especially hard. We argued that the increased number of Covid cases registered in Europe was “mostly related to the delta variant” but also specified that “other variants are likely to be in circulation as well.”
We have since had confirmation that a new variant, first identified in South Africa, has been recently added by the World Health Organisation (WHO) to the list of variants of concern. This new variant, dubbed Omicron (code name for B.1.1.529) presents 32 mutations of the spike protein, which the virus uses to infect the healthy cells of the human body. Some of these mutations were already present in previous variants, but some are new. There is a suspicion that the mutations have developed within the body of an immuno-depressed individual (perhaps affected by HIV), in which the virus had the opportunity to mutate and replicate.
Whatever the origin of the virus, the new strain has been identified not only in South Africa, but also in Hong Kong, in a passenger coming from South Africa. Several cases have also been identified in flights from South Africa to the Netherlands and in other European countries. This means that the new strain is already circulating internationally; it is only a matter of time before it will be widespread throughout the world. It is likely, given its “genetic superiority”, that this strain will become prevalent, like the Delta variant did a few months ago.
Though a number of countries have now banned flights from South Africa, this risks being a futile measure, as the virus has already reached several parts of the globe. Other countries have intensified the campaign for the third dose of the vaccine (the so-called “booster”).
But it will take time (at least two weeks, Pfizer said), to ascertain whether the new strain is able to circumvent the defences provided by the currently available vaccines. Pharmaceutical companies are saying that they are already working towards a new version of the vaccine, tailored to Omicron, but it will take at least three months before these vaccines may become available to the wider population.
Markets have already reacted to the news: fears of new restrictive measures, including new total or partial lockdowns that may derail the ongoing economic recovery, have resulted in market sentiment and equity prices plummeting. Last Friday some equity indices lost almost 5% in a day. Now the ball is in the court of policymakers attending to monetary and fiscal policy. How will these policymakers respond?
As we have discussed previously in several columns, central banks have been sending hawkish signals for months now, and some have already started to tighten their policy stance, in both DMs and EMs. The Fed started tapering its asset purchases in November, and the ECB announced in October that the pandemic emergency is over. Governments have started to plan measures of fiscal consolidation. Will they now all decide to put the reverse gear on? It’s too early to say. Paradoxically though, if the new variant results in further liquidity injections being made by central banks, in order perhaps to monetise additional fiscal deficits made by governments, markets may recover their recent losses and progress further towards future highs.
In any case, it seems to us that before the spring or summer of 2022 it will be very hard to tell if this pandemic is about to end, or whether new variants may emerge again.
by Brunello Rosa
22 November 2021
In a number of countries, but especially in Europe, an increase in the number of Covid cases has been registered in recent days. These are mostly related to the delta variant, but other variants are likely to be in circulation as well. In continental Europe, the most alarming countries have been Germany(with 60,000 new Covid cases per day), the Netherlands (20,000 cases), Austria (15,000), and Belgium (20,000).
Countries’ reactions to these outbreaks have differed. In Germany, the government has introduced the 2G rule, whereby only those who have recovered from Covid or who have undertaken a full vaccination cycle may receive a Green Pass to access public places. In the Netherlands a partial form of lockdown has been introduced. In Austria, a 20-day full lockdown has been ordered by the government, and vaccination will become mandatory from February 1st.
In Italy, where the number of new cases is still relatively low (around 10,000 a day), the government is considering a tightening of the Green Pass rules. The Covid test may be accepted only to go to work; it would not be sufficient for social events. The validity of the tests would also be reduced from 2 days to 1 day for antigenic tests, and from 3 days to 2 for PCR tests. The government is also thinking of making vaccination obligatory, but it may not find the internal agreement necessary for a green light on that.
Other European countries have reacted differently to the current situation. In the UK, for example, there has been a surge of new Covid cases since October. The number of new cases peaked in early October (at 51,000), and subsequently declined to around 40,000 now. Yet the government has resisted the pressure to introduce new restrictions after the “liberation day” was declared on July 19th. Instead the government accelerated the campaign for the booster shot of Covid vaccines, with the minimum time between second and third doses being reduced to 5 months.
The overarching principle in these government responses has been to preserve the recovery in economic activity, reduce the burden on fully vaccinated people, and incentivise (indeed almost oblige) those still reluctant to get vaccinated to get their shots. We agree with this approach. In principle, those who paid the price of getting vaccinated (in terms of the small risks associated with the process), to the benefit of the entire community, should be entitled to enjoy the benefits of more freedom of movement relative to the non-vaccinated, who risk their own and other people’s lives with their choice.
From an economic perspective, the consequences could be significant. After the link between Covid cases and economic impact had been severely reduced by the introduction of vaccines, the ongoing recovery in economic activity may experience a slowdown or a more significant and prolonged soft patch if new restrictive measures are introduced in large or numerous countries.
If the slowdown in economic activity growth proves to be deeper and longer-lasting than is currently assumed, policymakers may need to revisit their recently-expressed intentions. Governments may need to provide additional fiscal support, and central banks may need to rethink the phasing out of the extraordinary accommodation they have provided in the last couple of years. They may have to continue to purchase, for a longer period of time, private and public sector assets, and they may have to push back any intention of increasing their policy rates in the not-too-distant future.
If this proves to be the case, the implications for asset classes would also be large. Long-term sovereign bond yields would likely fall across the board. Equities may benefit from renewed liquidity injections, with EMs becoming interesting again. In the currency space, the USD may strengthen further versus European currencies, if the US government does not introduce new restrictive measures as much as the European countries will do.
by Brunello Rosa
15 November 2021
After a two-week marathon summit, an agreed-upon text finally emerged at the end of the CP26 conference in Glasgow. Signatory countries are committing to limit the increase in global temperature to well below 2C since pre-industrial times, and ideally to 1.5C. They are also committing to increase the funds available to help countries fight global warming and adapt to climate change. This 1.5C limit was already agreed on in Paris in 2015. The direction towards agreeing to these goals was established by the Kyoto Protocol in December 1997, when COP3 was held.
The problem here is that global temperature has already increased by 1.1C since pre-industrial times, and so long as the amount of CO2 injected into the atmosphere continues at the current, or even a slightly decelerated pace, one cannot see a meaningful deceleration for the increase in global temperatures in sight. Though reaching zero net emissions by 2050 (which in practice would mean emissions that are fully compensated for by offsetting actions, such as planting new forests), or even by 2030 – which some countries are pledging to accomplish - may help to achieve the final goal, nevertheless international cooperation remains of the essence.
In this respect, the final text of the COP26 contains an unwelcome last-minute change. Instead of aiming at “phasing out” carbon emissions, India has asked instead to phase them “down”, a significant softening of the initial proposal. Interestingly, while all eyes were focused on China, ultimately it was India that managed to water down the agreement. India is the country in the world that most relies on carbon emissions to satisfy its production needs, despite the fact that its per capita energy usage remains well below that of China or developed economies.
This agreement therefore makes clear once again the division existing between emerging economies and developed countries. The latter are reluctant to provide the financing that is needed to smooth the transition toward a more ecologically sustainable economy. Meanwhile the emerging economies wonder why limits to pollutions are now being imposed upon them by developed countries, as it is the developed countries that are primarily responsible for the increase in global temperature from the beginning of the industrial revolution.
The United States, for example, is estimated to have been responsible for 25 percent of cumulative emissions worldwide since pre-industrial times, compared to 13 percent for China and only 3 percent for India.
What is positive about this new agreement? To begin with, having reached an agreement is an accomplishment in itself. Especially after the entrenchments between countries caused by the ongoing pandemic, it was not a given that a cooperative spirit would still be present internationally. Secondly, the agreement (however vaguely) does provide guidelines to implement the principles agreed upon six years ago in Paris. Third, it is important that most of the main actors of the global economy were at the table: the US, China, the EU, and India (among the 197 participating members), though Russia remained on the sidelines.
The US returned to the table at Glasgow after the pull-out decided on by Donald Trump, with Joe Biden’s chief negotiator John Kerry being a heavyweight in US politics (Kerry was the Democratic presidential candidate in 2004, and the Secretary of State during Barack Obama’s second term as president). Chinese leaders initially attended the conference only virtually, but its contributions to the negotiations were felt all the same. The EU, meanwhile, was clearly one of the most sensitive participants, in that it has been one of the main advocates of the fight against climate change, and in this respect the speech by the EU Commission Executive Vice President Timmermans was considered a final push towards reaching an agreed statement.
Between the US and the EU, there is clearly a different approach towards addressing China. The US is continuing to forge a hard line here, given the emerging Cold War II that is being waged between the two countries, as well as amid US allegations of China having started the global pandemic. The EU is softer on China mainly for commercial reasons, but also because the EU knows that one cannot constructively engage China on global warming if one continues to treat China as a strategic rival that needs to be contained.
It is hard to say whether the COP26 result was a glass half full, or half empty, achievement. The objectives that were agreed to are clearly unambitious, and the lack of urgency regarding emissions reduction continues to persist in many countries. On the other hand, any agreement that fosters international cooperation and multilateralism is good in these fractious times.
by Brunello Rosa
8 November 2021
There were three major central bank decisions among the G10 economies last week. In the US, the Federal Reserve decided to reduce the pace of its asset purchases by USD 15bn a month (USD 10bn of Treasuries and USD 5bn of MBS), beginning as of this November. As we discussed in our review, the Fed will retain some flexibility regarding the pace of further reductions, as the FOMC is aware that the winter season could see a spike in Covid cases and potentially new restrictive measures, and thus any decision may need to be reversed at short notice. Even in China, the zero-Covid policy is proving ineffective in spite of the country’s strict enforcement.
The Fed made this decision to reduce asset purchases independently of any fiscal policy consideration, but nevertheless it is a fact that during this same week the US Congress passed the long-waited USD 1.2tn infrastructure investment plan, which will provide fiscal support to the ongoing US economic recovery. President Joe Biden promised to pass an additional USD 1.75tn package to invest in the country’s social safety net in the coming weeks, but considering the wrangling that has been necessary to pass this bill in Congress, such additional spending seems “aspirational.” Democrats and Republicans have also fought recently over the increase of the debt ceiling – a battle that is likely to re-start in December. Also, Biden may need to act carefully while his approval rating is tanking (though it is not clear whether his approval has fallen because he is perceived as being too progressive by the moderate base of his party, or too moderate by the progressive side of his party).
In this informal coordination between monetary and fiscal policy, an important step will be the appointment of Jay Powell’s successor as Fed Chair during the coming term, which will start at the end of February 2022. It is worth remembering that the current Secretary to the Treasury, Janet Yellen, is a former Chair of the FOMC. Again, the two sides of the Democratic party will likely have different views as to this re-appointment. Lael Brainard, however, who has served on the Fed’s Board of Governors since 2014, is touted to be on the shortlist of potential candidates to succeed Powell.
In the UK, meanwhile, the Bank of England left its policy rate unchanged, surprising the markets, which in the past few weeks had been alerted by the Bank itself about a possibly imminent rate increase. As we discussed in our preview, from a normative perspective we thought that the Bank could afford and should wait at least until February before raising rates. So, to some extent we were glad the Bank made that decision. On the other hand, we remain highly sceptical of the Bank’s communication, which clearly wrongfooted the market. In this case, the BoE also had the benefit of looking at the details of the budget plans of the UK government for 2022 and beyond. They probably saw that the budget plans were not as generous as one could have anticipated, implying that the country had to rely on additional monetary support from the central bank instead.
In Australia, the RBA left its policy rates unchanged but brought forward the time in which raising rates could happen (from 2024), and de-facto ditched the yield curve control on the 3y government bond yield. This relatively hawkish move also came after the Australian treasury released a very expansionary budget in May and allowed the deficit to increase substantially over the course of the year, which permitted the central bank to start withdrawing some of their policy accommodation.
As we discussed at the beginning of this crisis, the coordination between monetary and fiscal policy has been the real innovation of the crisis. It is good news that this coordination continues as public authorities now withdraw the extraordinary stimulus provided during the crisis.
by Brunello Rosa
1 November 2021
The Italian presidency of the G20 forum concluded this past weekend with the G20 meeting that was held in Rome. All the head of states of the twenty largest economies in the world gathered in Rome to discuss key themes such the fight against the pandemic (and against pandemics in general), climate change, and the implementation of a minimum corporate tax rate.
Regarding the pandemic, the G20 highlighted the importance of continuing and intensifying the vaccination campaigns in those countries that have already started them, and of pushing further for a fairer distribution of vaccines around the globe, particularly for developing economies. The target to reach is having 70% of the world population vaccinated by 2022. The monetary and fiscal response to the pandemic needs to remain coordinated to avoid beggar-thy-neighbour behaviours. G20 leaders also pledged to make their economies more resilient to future pandemics, which may become more frequent in coming decades as the world population increases. Attending the conference remotely by video, the Chinese president Xi Jinping asked that the discussion about the origin of the virus not be politicalized excessively, saying that doing so does not help the international cooperation and solidarity needed in the face of the ongoing emergency.
Regarding the minimum corporate tax rate, the G20 has adopted the recommendations made by the G7 group, which first pledged to implement a minimum corporate tax at 15% in their economies. As we discussed at that time, the logical sequence was for G7 countries to first propose and adopt a policy of this kind, which is a key measure for social justice, and then enlarge its adoption to G20 countries and eventually at the OECD level, with 38 members including many EMs such as Colombia, Mexico and Costa Rica.
On climate change, the G20 highlighted once again the strong connection with pandemics, the two being aspects of the same phenomenon. We discussed in the past how, in our opinion, both climate change and pandemics derived in large part from the rapid rise in the world’s population, which has doubled in the last 40 years to 7bn people and is may reach 11bn by 2050. But clearly most of the advancement of the discussion on climate change will be made in Glasgow, when the crucial COP26 starts on Monday. We remain sceptical that lots of progress will be made, especially as China is clearly not engaging in the discussion. Without China’s strong commitment to reduce its carbon emissions, any effort to reduce gas emissions would be almost in vain, even if all other major industrialised economies were to reach carbon neutrality by 2040-2050.
There will also be two crucial central bank meetings this week. On Wednesday, the US Federal Reserve will likely announce the beginning of tapering of its asset purchases. As we discuss in our preview, this may happen in November or December, but the direction of travel seems set at this stage. The Bank of England will meet on Thursday and will confirm that it is ready to increase its policy rate – an action that could take place during that November meeting as well (as we discuss in our preview). When two of the four largest central banks in the world begin tightening their policy stance, it means we are at a turning point in the policy response to the pandemic and its economic repercussions.
by Brunello Rosa
25 October 2021
On July 19, the UK celebrated what was emphatically labelled “Freedom Day:” the end of all restrictions related to the pandemic after the difficult months of the second lockdown, which had been particularly severe. More recently, though, the summer holidays, the gradual re-opening of the economy, the return of social interaction without social distancing, and the spreading of the Covid Delta variant have all contributed to a rapid increase in Covid cases.
According to government statistics, there are around 40,000 new daily cases of people having tested positive to Covid, and 330,000 new weekly cases. That is a 9.4% increase compared to the previous week. The number of people admitted to hospitals has also increased (it has surpassed 1000 cases daily), and the number of deaths is also increasing (it reached 72 per day and almost 1000 per week). This is also due to the spreading of a new sub-variant, called AY.4.2, VUI-21OCT-01 or “Delta Plus”, which is thought to be up to 10% more transmissible than the original Delta. The new sub-variant is responsible for 6% of the new cases recently registered in the UK.
For this reason, the government is said to be preparing to implement the so-called Plan B, which would include the return of certain restrictions, such as wearing masks in some public spaces, the obligation to show a “green pass” to attend some events or public places, and the suggestion of working from home whenever possible.
If these new restrictions are adopted, this would likely result in less dynamic growth in economic activity, which was already downgraded by the IMF in its latest World Economic Outlook (as we discussed last week).
All this is happening at a time when the UK is already going through a very challenging period, in which it is having to deal with the effects of the pandemic and Brexit at the same time.
The result has been labour shortages in a number of sectors, including hospitality and logistics, with the dearth of workers that can legally operate as waiters, car or truck drivers, for example. All this compounded the effects of higher gas prices, which led to the gasoline shortages at pump stations of a few weeks ago and the absence of key products (such as mineral water) in the shelves of supermarkets. Inflation, meanwhile, has reached 3.2% recently, and is expected to reach 4% or even 5% in coming months.
Facing all these emergencies at the same time, what’s the policy response of the authorities? As far as fiscal policy is concerned, this Wednesday the UK Chancellor of the Exchequer will deliver its annual budget, which is expected to bring – among other measures - a new spending review, new investments in education, culture, digitisation of public administration. However, the budget is not expected to massively deviate from the gradual fiscal consolidation path that was envisioned when an increase in corporate tax rates was announced months ago.
Monetary policy is also on the move, with the Bank of England expected to have “a live debate” on November 4th, when the new Monetary Policy Report will be issued, on whether or not the BoE should increase its policy rate by 15bps to 0.25%. At this stage, the MPC seems inclined to go in that direction. However, if the government will implement new restrictions and economic activity will suffer as a result of it, a rate increase in 2021 may prove premature.
by Brunello Rosa
18 October 2021
Last week, the International Monetary Fund and the World Bank held their annual meetings, once again in virtual formats given the recurrence of the Covid-19 pandemic given the rise of the delta variant. The IMF released its latest edition of the World Economic Outlook (WEO), titled “Recovery During a Pandemic. Health Concerns, Supply Disruptions, and Price Pressures.” The heading summarises the content by saying: “Global recovery continues, but the momentum has weakened and uncertainty has increased.”
In fact, the Outlook has revised the forecast for global growth in 2021 downwards, from 6.0% to 5.9%, as US growth was revised down by 1% from 7.0% to 6.0%. Growth has been revised down in other major advanced economies as well, including in Germany, UK, Japan, and Canada, but by a smaller extent. China’s growth was also revised marginally down by 0.1%, to 8.0%. At the same time, inflation projections in 2021 and 2022 have been revised upwards in advanced economies (by 0.4% to 2.8% and by 0.2% to 2.3%, respectively) and in emerging markets (by 0.1% to 5.5% and by 0.2% to 4.9%, respectively).
These changes in forecasts chime with our own view, which is that there may be stagflation risks in the short and medium term, as we discussed in a recent column. In the short run, economic activity is endangered by disruptions in global supply chains, and by new restrictions deriving from the recrudescence of the pandemic, given the uneven distribution of the vaccines across the globe and their reduced efficacy a few months after injection. Short-term economic activity may also be endangered by diminished consumption as a result of higher energy prices.
Inflation meanwhile is subject to upward pressures deriving from higher energy prices (in particular gas prices), base effects, the re-opening of specific sectors of the economy that were hit particularly bad by the pandemic (e.g. tourism and hospitality) and disruptions in global value and supply chains.
In the medium term, stagflation risks emerge as inflation is subject to upward pressure from ongoing phenomena such as de-globalisation, a less inequal distribution of income between labour and capital (epitomised, for example, by an increase in minimum wages), balkanization of supply chains, debt monetisation and ecological transition processes; while growth in economic activity is endangered by prospective fiscal consolidation processes, monetary policy normalisation, disruption in global supply chains, and the economic impacts of ecological transition.
The WEO also highlights the rise in uncertainty going forward, mostly due to policy actions. In the midst of the crisis the policy response was one-directional: easier monetary and fiscal stances emerged across the globe, in developed and developing economies. But in a recovery phase, the policy responses become more mixed, depending as they will on the idiosyncratic circumstances of each country. We have certainly noted a tendency toward tighter monetary policies in both DMs and EMs, but the degree of reduced accommodation varies greatly across the globe. All this is reflected in financial markets, which have experienced higher volatility in recent weeks, in equities, bonds, and currencies.
by Brunello Rosa
11 October 2021
The Reserve Bank of New Zealand (RBNZ) increased its main policy rate by 25bps last week, to 0.50%. This move was its first rate increase since 2014, and marked the end of the policy easing cycle that began in 2019, back when the US Federal Reserve implemented its three “precautionary rate cuts”, before the Covid-19 pandemic was even on the horizon.
As we said in August, the RBNZ was already ready to increase its policy rate this summer, but the sudden decision by the government to impose a national lockdown following a new Covid outbreak in Auckland convinced the central bank to postpone the announcement until October.
What is interesting in the decision by the RBNZ is not just the recognition that the lockdown will lead to a localised contraction in economic activity, but also that the government has the tools to cushion its economic impact, and that the economy will be able to rebound quickly after these periods of contraction. As such, the Bank’s Monetary Policy Committee decided to carry on with the planned tightening of monetary policy, to counter the impact on inflation of rising capacity constraints.
The RBNZ is the second central bank among the G10 economies to increase its policy rate during this cycle. The first was Norway’s Norges Bank, which increased its key sight deposit rate by 25bps at the end of September, to 0.25%. The Norwegian central bank had already telegraphed its intentions to do so in June, when it explicitly said that if the economy performed in line with its policy committee’s expectations, the central bank would have to increase its main policy rate by 25bps. In this case, the Norwegian economy was benefiting from the rise in oil and energy prices as well, being a net exporter of oil.
These central bank decisions are coming after the ECB decided to “recalibrate” its Pandemic Emergency Purchase Program (PEPP) in September, and, most significantly, after the US Federal Reserve pre-announced its intention to taper its asset purchases by the end of the year.
Some analysts are now wondering whether the weak US employment report in September, showing only 194,000 new jobs being created compared to the 500,000 that had been expected, may delay the decision to taper QE. During his latest press conference, Chair Powell said that he needed to see a “decent” employment report to be satisfied with the condition that further progress had been made towards achieving the Fed’s employment target. It is difficult to know whether an increase of less than 200,000 jobs fits the bill, even as the unemployment rate falling to 4.8% (vs. the 5.1% that had been expected) is certainly an upward surprise.
If the RBNZ example can be of any guidance for what the Fed may decide to do, it may show that central banks are not likely to be disturbed by short-term volatility of economic variables, and will carry on with their stated intentions. At the same time, central banks want to err on the safe side so long as the pandemic continues and there is still a risk of new variants emerging.
In any case, as we discussed in previous columns, the direction that G10 central banks are heading in seems to be well established. In the coming months most central banks will start to withdraw the extraordinary stimulus provided since the beginning of the pandemic, while continuing to provide the necessary backstop to governments and their expansionary fiscal policies
by Brunello Rosa
4 October 2021
In March 2020, the world economy came to a standstill as half of the global population was forced into partial or total lockdowns. Economic activity collapsed by double-digit percentages. Oil prices went negative for the first time in history, as the price of storage soared while the use of energy sunk. Market dislocation at that time was unprecedented, with US Treasuries temporarily losing their safe-haven status.
Given the scale of the shock, the disruption in real economic activity and in financial markets that followed could be expected, as could have been the swings in GDP growth and in the prices of assets, goods and services, not just on a quarterly basis but also on a year-on-year basis, given base effects. Central banks have been keen in pointing out the temporary nature of these shocks, and in asserting that because of this temporary nature they needed to be patient, and not react precipitously.
As we approach the end of the second year of the pandemic (if we assume November-December 2019 as the starting point) we see that some of the imbalances created by the pandemic are being re-absorbed, as testified by the fall in unemployment rates throughout emerging markets and advanced economies. On the other hand, other types of disruptions are starting to emerge.
Globally, the shortage of semiconductors for microchips is causing a temporary stoppage in the production of automobiles. Supply bottlenecks in general have increased over time, given the temporary closure of factories and mines in some key emerging markets, such as China, and in developed economies.
These supply shortages so far have resulted in higher costs, but may soon result in slower economic growth, a sort of stagflation that could derail the global recovery from the pandemic.
In the UK, the effects of supply bottlenecks are added to those of Brexit: shortages of truck drivers have resulted in a dearth of fuel, with cars queuing for hours to get their tanks filled. In mainstream supermarkets it is hard to find bottled water. The government has asked the army to intervene, and does not seem inclined to allow a higher number of visas to be granted to foreign workers in order to alleviate the labour shortages.
We are not particularly worried about this short-term disruption of supply chains. Rather, we fear the balkanization of global supply chain that is likely to occur over the medium term, induced by the ongoing process of de-globalisation (even if such de-globalisation means making certain supply chains more reliable). But a shorter supply chain most likely means higher prices in the medium term, as we discussed in a recent column. The recent case of Australia cancelling its submarine order from France is an example of how supply chains may suddenly change in this post-pandemic, post-Brexit, bi-polar world, with the increased rivalry between US and China.
Clearly, if central banks realise that these supply shortages are more persistent than is currently believed, they may decide to react accordingly and reduce the amount of policy accommodation they are now providing earlier or by a greater amount than is currently envisaged. This in turn would have serious repercussions throughout financial markets.
by Brunello Rosa
27 September 2021
We have been discussing Germany's elections for months now. In our initial piece of analysis, we discussed Germany’s international position, noting how the CDU leader Armin Laschet was aiming for a more neutral position for the EU between the US and China. We discussed, for example, how Laschet took the German state of North-Rhine Westphalia, which he has run as Minister-President since 2017, and made it the hub for Chinese activities in the country. In a second piece on domestic politics, we noted how Germany, even with a new Chancellor, was ready to continue running the same course that Merkel has been leading the country on, as long as that new Chancellor is centrist and moderate. In a final preview, we noted how the CDU/CSU were losing ground in the polls to the advantage of the SPD, and how this meant that Germany would need a three-party coalition to form a government.
This scenario has now materialised, with the polls closed and the provisional results showing the SPD ahead with around 26% of the votes, followed closely by the CDU with 24% and the Greens with 14.8%, the FDP with 11.5%, AfD with 10.3% and Die Linke (The Left) with 5%. What we already know is that we will need a three-party coalition to form a government, and such a coalition could be either the SPD, Greens and Liberals (the “traffic light” coalition), the CDU, Greens and Liberals (the “Jamaica” coalition), or the SPD, CDU and Greens (the “new Grand Coalition”). But other possible, albeit less combinations could also emerge, involving Die Linke or AfD.
Some of the lessons we can learn from these polls include the following:
1) The era of stability in Germany is effectively ended, with the fragmentation of the political system requiring a three-party coalition being formed following lengthy negotiations, which could last for months before a “coalition contract” is finally signed.
2) The impact on the European integration process could be significant, as Germany remains the cornerstone of every key EU decision. France with President Macron and Italy with PM Draghi seem ready to take the baton from Germany in leading the next phase of the integration process, in which important decisions need to be taken regarding foreign policy and defence matters, among other things.
3) A positive aspect of these elections is that the anti-EU, anti-system parties seem to be out of the picture for now, marginalised by the system. Clearly, though, these parties may be called in to help form a government if all other coalition options prove to be undoable.
4) As we discussed in our recent column, this means that Germany remains committed to the European project, and that one of the three key elections of 2021-22 has not gone wrong just yet. However, the success of this election cannot yet be taken for granted either, and we still need to wait for the result of the Italian and French presidential elections in order to be sure that the EU integration process is not D.O.A.
Once the composition of parliament is completed it will become clearer what coalitions are actually feasible in parliament and not just on paper. It will be hard for anyone to form a government, but the ability of a party to form a coalition will be more relevant than finishing first in the polls.
That is why Armin Laschet could still become PM even if the SPD end up the party with the most votes. It is likely that long negotiations will now begin, under the auspices of the President of the Republic Frank-Walter Steinmeier. Whichever coalition eventually emerges, Germany will express one of the weakest governments it has had in the last 40-50 years. This cannot be considered good for the rest of Europe.
by Brunello Rosa
20 September 2021
A couple of years ago, when the pandemic was not even on the horizon and populist parties were on the rise throughout Europe, we identified the September 2021 – June 2022 period as the moment of truth for European politics. Three key elections at the EU (and Eurozone) level will take place during this period. First, on Sunday 26thSeptember, the German general election will take place. Several months later, in February 2022, will be the Italian Presidential election (carried out by a special electoral college, including all MPs and regional representatives). Finally, in April there will be the French Presidential election, which in turn will be followed by France’s parliamentary elections in June. As we discussed in depth in a previous analysis, if any of those crucial events were to result in the victory of anti-system, anti-European candidates, the European integration process may stall indefinitely, and perhaps reverse further than it has already with Brexit.
As we discuss further in our forthcoming preview of the German election (after the in-depth analysis we published recently), the race has become more interesting than one could have expected. The choice of unsuitable candidates from the Greens (Annalena Baerbock) and the CDU/CSU (Armin Laschet) for the Chancellorship has given an unexpected boost to the SPD candidate Olaf Scholtz, who is now clearly leading the polls. Many combinations and permutations of coalitions will be attempted after the vote, but if the actual votes confirm the polls then it seems that a three-party coalition will be needed to form a government in Germany, for the first time since WWII. The so-called “traffic-light” SPD-Liberals-Greens coalition and the so-called “Jamaica” CDU-Liberal-Greens coalition appear to be the most likely to emerge. These coalitions are likely to be tenuous at best, and prone to collapse given cultural and political differences. The point is this: if Germany becomes politically unstable, that cannot be good either for Germany or – most importantly – for the EU and its integration process.
The Italian presidential election is also going to be a crucial moment. All eyes will be on Mario Draghi, and whether he will move from Palazzo Chigi to the Quirinale Palace. This could mark the beginning of renewed political instability in Italy, or the interruption of the reform project undertaken by Draghi’s government as a result of the Next Generation EU plan. The importance of the President in Italy is often underestimated, as is the crucial role Italian presidents have played in dampening the populist pushes within the country’s political system, or in preventing severe deviations from the Constitutional norm and spirit from taking place. Italy remains a cornerstone of the European project (one of the six founding members), and we have already seen how problematic EU policymaking becomes when Italy elects anti-system or populist leaders.
The French Presidential election is also crucial, especially if Germany become less of a bastion of stability in Europe. In theory, President Macron should have a relatively easy ride towards being re-elected, but in reality Marine Le Pen continues to be very close to President Macron in the polls for the second round of another election between them. Needless to say, if Le Pen were to become President, this would be yet another “French revolution”, which would likely mark the end of the EU integration process. President Macron still has time to recover, but he is going to face an uphill battle in this campaign.
In conclusion, the EU is about to enter its most delicate period of any time in the last few years, with the EU integration process at risk of derailment in coming months. A political derailment of this kind would have clear implications for the ECB’s policy stance and market dynamics.
by Brunello Rosa
13 September 2021
In the last few months, the US and other advanced economies have witnessed the highest rates of inflation for decades: headline inflation reached 5% in the US and 3% in the Eurozone, with core inflation (which excludes energy and food prices) also on the rise, sometimes significantly.
These inflation rates, unseen for many years, have spooked market participants. Inflation erodes the real value of investments in equities, bonds, real estates and, if central banks were to increase their policy rates to stem rising inflation (considering that price stability if often their first, if not their only mandate), higher market rates would ensue: any valuation model based on discounted cash flows would observe a rapid fall in valuations if market yields used to discount future cash flows (either coupons for bonds, or dividends for equities) were to increase.
Most of these recent price increases have been linked to the reopening of the economy after the global shock experienced in 2020 due to the pandemic. The rise in energy prices due to the rebound in economic activity has resulted in an almost 1:1 increase in headline inflation. Base effects have played a large role as well. In Q2 2020, headline inflation collapsed (also as a result of tanking oil prices): one year later, not surprisingly, these effects have been reversed. The reopening of the economy in specific sectors that came to a sudden halt during the pandemic (car rental, hospitality, travel, just to name a few) has meant selective increases in prices in those sectors, weighing on the overall inflation gauge.
Supply side bottlenecks are having a large impact as well: when the availability of crucial components in several global supply chains (such as semiconductors for the car industry) collapsed, prices of the scarcer goods increased. Finally, some specific one-off factors (such as the reversal of previous VAT cuts, such as those implemented in Germany to stimulate economic activity) have played a role in the recent increase in inflation rates observed globally.
For most central banks, these inflation spikes are temporary in nature, and will likely reverse themselves as soon as all these one-off factors wash out of the inflation calculations in coming months. However, some of them are starting to take some insurance against rising inflation ahead, by reducing the rate of monetary easing, lastly the ECB, which last week decided to buy EZ government bonds at a modestly lower pace in Q4 2021 compared to the first two quarters of the year.
While we tend to agree with the central banks’ assessment, implying that market worries are probably exaggerated at this stage, we would highlight the medium-term risks of structurally higher inflation. After the pandemic, and especially considering the strained US-China relationships on the origin of the Covid-19 pandemic, global supply chains have been cut off and will likely be much shorter in coming years. Shorted supply chains are likely to be more robust and resilient, but are also conducive to higher prices: the dis-inflation experienced by the world as a result of China’s entering the global economy during the 1990s has likely come to an end and will likely reverse itself in coming years.
Also, the unequal distribution of income, with progressively less attributed to the labour share and more to profits and rents since the 1970s has reversed itself, perhaps also as a result of the populist polices envisioned by many world leaders, including in the US. They also include an increase in minimum wages in a number of countries.
These factors (shorter and balkanized value chains, higher minimum wages, more income attributed to the remuneration of labour rather than capital) will likely imply structurally higher inflation rates in the medium term. They may also imply a more subdued growth environment (for example to repay the large amount of debt issued during the pandemic), in which case we would observe stagflation rather than simply inflation. This increased risk, and its seriousness, has been highlighted by Nouriel Roubini in a recent article.
by Brunello Rosa
6 September 2021
Taliban troops regained control of Kabul around three weeks ago, after having seized large parts of Afghanistan. The images of the Taliban entering the capital sitting on top of dusty tanks have been shown all around the world. By using traditional weapons, in a territory still seemingly controlled by the most sophisticated army in the world, that of the United States, the insurgent group managed to become once again the rulers of the central Asian country, 20 years after the last time they were in power.
Even worse than that, the US have left behind traditional weapons of all sorts, worth billions of dollars. According to the US Government Accounting Office (GAO), the US army has left something like 42,000 pick-up trucks and SUVs, 8,000 trucks, 22,000 Humvees, almost 900 armoured vehicles (including 169 M113), 100 helicopters, 75 airplanes, 560,000 rifles, guns and machine guns, and 176 pieces of artillery.
All these weapons will constitute the basis for the new Afghan army controlled by the Taliban. It is hard to imagine a peaceful use of all these weapons. In any case, the Afghan revolt was an example of a very traditional way of conducting wars: boots on the ground, rifles, tanks, talks conducted far away from the battlefield (in this case, in Doha, Qatar).
But besides this old-fashioned form of warfare, a new, much more technologically advanced way of conducting wars is emerging. According to a recent article, in the May 2021 conflict between Israel and the Palestinians, the Israeli army deployed AI and supercomputers to identify and strike targets, in what has been labelled the “first artificial intelligence (AI) war.” The Israel Defense Forces “used a swarm of AI-guided drones and supercomputing to comb through data and identify new targets within the Gaza Strip.
It's thought this is the first time a swarm of AI drones has been used in combat.” Supercomputers searched through a mountain of data that had been collected using a combination of “signal intelligence (SIGINT), visual intelligence (VISINT), human intelligence (HUMINT), geographical intelligence (GEOINT) and more”, to be able to identify targets to strike.
This type of hybrid war is likely to become the standard for conflict in coming decades, whereby humans will be assisted, if not totally substituted, by robots, AI and other technological tools for military operations on the ground. Yet already most conflicts are not even fought on the ground: the preferred battlefield for a number of organisations, whether governmental or non-governmental, is becoming the cyber space. In this environment, humans are always in the background, and the battle is fought by the machines, through algorithms and artificial intelligence.
A recent report by the United Nations’ Office of Counter Terrorism, titled “Algorithms And Terrorism: The Malicious Use Of Artificial Intelligence For Terrorist Purposes” discusses how “terrorists have been observed to be early adopters of emerging technologies, which tend to be under-regulated and under-governed, and AI is no exception.” The study reports how “it is predicted that the global AI market will exceed USD 100 billion by 2025 and AI enabled systems will continue to support many sectors – healthcare, education, commerce, banking and financial services, critical infrastructure, and security, among many others.”
It is very likely that the wars of the future will be much more technological in nature, with a larger use of artificial intelligence and less use of boots on the ground, except in such cases where they are deemed absolutely necessary.
by Brunello Rosa
30 August 2021
In our column last week we wondered whether or not Jerome Powell, the Chair of the Federal Reserve’s Open Market Committee (FOMC), would suggest a change in the US central bank’s policy stance during his speech at the annual symposium of central bankers and academics in Jackson Hole, Wyoming. The meeting, initially scheduled to take place in a live, in-person format, eventually took place virtually instead, given the recent resurgence of Covid cases in the US due to the spreading of the Delta variant.
The speech, titled “Monetary Policy in the Time of COVID”, discussed the various phases of economic activity experienced by the US economy since the inception of the pandemic, from the pre-pandemic slowdown whichll led the Fed to three pre-emptive rate cuts in 2019, to the sharp recession in 2020 (with drops in economic activity of unprecedented scale), and finally to the recovery phase, which started in Q3 2020 and, despite plenty of bumps along the way, still continues today.
The most relevant part of the speech was about the progress made towards meeting the two targets of the Fed: inflation and employment. Regarding inflation, Powell said that sufficient progress was made towards assuring that US inflation will be 2% over the forecast horizon on average. The recent spikes of inflation to 5% and beyond derive from “temporary factors” such as higher energy prices, base effects, supply bottlenecks and the re-opening of the economy in some specific sectors. The Fed is monitoring wages and inflation expectations to check whether inflation risks spiralling out of control. That is still a low-risk scenario at this stage.
Regarding employment, Powell said that more progress needs to be made towards meeting the target not just from a quantitative perspective, but also from a qualitative point of view. Yes, the unemployment rate has fallen significantly from its peak, and is now at 5.4%, but according to Powell it “is still much too high, and the reported rate understates the amount of labor market slack. Long-term unemployment remains elevated, and the recovery in labor force participation has lagged well behind the rest of the labor market, as it has in past recoveries.”
On the back of these considerations, and repeating what the minutes of the July FOMC meeting said, Powell concluded that “if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.” This will not provide, Powell said, any indication of when the Fed will start increasing rates, “for which [the Fed has] articulated a different and substantially more stringent test. [The Fed has] said that [it] will continue to hold the target range for the federal funds rate at its current level until the economy reaches conditions consistent with maximum employment, and inflation has reached 2 percent and is on track to moderately exceed 2 percent for some time.” And that is still some time away from happening.
In conclusion, Jackson Hole provided the type of signal that market participants were looking for. If the economy evolves in line with current forecasts (which will be updated in September), the Fed may begin to taper its QE in December. This means that a formal announcement may come in September or November, but at this stage it will not make a massive difference. The market took the news out of Jackson Hole quite positively, as Powell’s hint was so nuanced and caveated that participants expect the Fed to always err on the cautious side. And so do we.
by Brunello Rosa
23 August 2021
This year, between August 26 and 28, the annual symposium of central bank governors and academics organised by the Kansas City Fed and held in Jackson Hole will return to a “live” format, after the 2020 edition was held in virtual format due to the pandemic. In the past, Jackson Hole was the occasion at which central bankers announced significant changes in the policy stances of their institutions, based on research presented in the informal and relaxed environment provided by the resort in the mountains of Wyoming.
Market participants are anxiously waiting for the speech by Jerome Powell, the Chair of the US Federal Reserve, which he is scheduled to give on Friday. They expect Powell to provide details about a possible change in the Fed’s policy stance, such as the beginning of the tapering in asset purchases. Currently the Fed buys USD 80bn/month of US Treasuries and USD 40bn/month of mortgage-backed securities (MBS). The Fed, through its usual communiques and press conferences, has been very careful not to provide hints of an imminent beginning of tapering. This is to avoid the repeat of the so-called “taper tantrum” of 2013.
On that occasion, Fed Chair Ben Bernanke, during a Congressional testimony, indicated that the Fed will reduce the pace of its asset purchases, which it had been carrying out since 2008, “at some point”. That was enough for market participants to anticipate the beginning of the tapering process and fully discount it in market rates, which rose rapidly as a result, leading to a strengthening of the USD and a sudden outflow of funds from Emerging Markets. This year, in contrast, many EM central banks have already started to increase their policy rates, in anticipation of the Fed’s reduction in accommodation. In any case, the Fed will want to avoid the repeat of a similar episode to that of 2013, which caused a turmoil in financial markets for several weeks.
So far, the Fed has said that until sufficient progress has been made towards meeting its employment and inflation targets, the Fed will not change its policy stance. However, in July Powell said that the FOMC had taken its first “deep dive” into the timing, size and composition of its asset purchase program. Additionally, the minutes of the July meeting showed that a majority of FOMC members thought that, if the economy evolved in line with the FOMC’s Summary of Economic Projections , the beginning of tapering should then be announced between September and December.
We still expect the FOMC to formally announce tapering in December, but the meetings in September and November should acknowledge the progress made in meeting the policy goals. In Jackson Hole, the Fed will likely set the scene for these announcements to take place between now and the end of the year, supported in its decision to do so by evidence provided by its research staff.
by Brunello Rosa
16 August 2021
Yesterday newswires around the world reported that Taliban troops have regained control of Afghanistan’s capital, Kabul. This comes after several days of advancement of Taliban troops within Afghan territory, which led them to regain the control of large cities such as Jalalabad. The news now is that the Taliban have entered the Presidential Palace, President Ghani having already fled the country. The Taliban have affirmed their intention to declare the re-birth of the Islamic Emirate of Afghanistan.
Other press reports suggest that the two sons of historical figures such as the Mullah Omar (the emir of the Islamic Emirate of Afghanistan from 1996-2001, which hosted the militants of Al-Qaeda before the 9/11 terrorist attacks) and Massud (Aḥmad Shāh Masʿūd, the so-called Lion of Panjshir, the hero of the war against the Soviets in the 1980s, who was assassinated by Al-Qaeda two days before 9-11) are engaged in a distant race to become leader of the country now that it has been “liberated” by the presence of foreign troops for the first time in twenty years.
In fact, all this is happening while foreign troops are engaged in a complicated mission of withdrawing from this theatre of war (or, to put it more diplomatically, are withdrawing from their peacekeeping mission). There are images of helicopters evacuating the last US troops left in Kabul, which resemble the images of the Americans leaving Saigon at the end of the Vietnam war. For this reason, some are calling this episode “Biden’s Saigon,” even if the two episodes cannot technically be compared from a military perspective.
All this has been happening while there were “peace talks” going on in Qatar, aimed at finding a compromise solution for the country after the US and other major countries have withdrawn. But these peace talks have now been overtaken by events and are effectively useless. If the Taliban wanted international recognition and legitimacy, nothing better than regaining control of the capital and the presidential palace could guarantee such a result. It is highly likely than the Taliban will impose on the country a new Islamic regime. Whether they declare it a new Emirate or any other denomination makes little difference at this stage.
With the Taliban having regained control of Afghanistan, a long cycle begun in 2001, in the aftermath of the terrorist attacks in the US and the launch of the “war on terror” by George W. Bush, is coming to a very sorry end. USD 2 trillions of dollars spent in military expenses, many thousands of troops sent by dozens of countries over the last 20 years clearly have not been sufficient to stabilize a country that has been devastated by several decades of wars in the last century.
Similar to what happened in Iraq and Syria, where the Islamic State (ISIS) took control after the US troops and their allies left the country (after which it took many more years of fighting to push ISIS back), the risk is that Afghanistan may become once again a place where terrorists from all over the world may convene and hide. The hope is that world leaders will find a diplomatic solution to prevent this from happening. The UK premier Boris Johnson has already recalled parliament to discuss this issue and urged international unity on this matter. Other leaders will likely follow suit.
by Brunello Rosa
9 August 2021
As we have discussed in several previous columns, the world is being hit by the delta variant of the Covid-19 pandemic. This variant is considered to be much more transmissible than the beta variant, which was in turn more infectious than the original virus isolated in Wuhan. It is not yet clear whether this new variant is also more deadly than previous strains, in part because it is hitting countries with widely differing vaccination rates. In any case, infection rates are increasing globally. The US, for example, is now back to 100,000 new cases per day.
For this reason, several governments are intensifying their vaccination campaigns and are providing either incentives or threatening to impose restrictions on the unvaccinated segments of their own populations. In the US, the government promises USD 100 to citizens willing to get the vaccine. In Europe, several governments are adopting “green passes” that citizens must show if they want to attend public events or enter bars, restaurants, museums, etc. At the same time, most governments and central banks have noted how the economic impact of Covid has been decreasing over time, most likely as a result of the vaccination campaigns, which are reducing the hospitalisation of patients.
In effect, economic activity is enjoying the long-waited rebound following the end of the severe restrictions imposed until Q1/Q2 2021, before which time generalised or localised lockdowns and widespread bans on domestic or international travel were in place. Public and private forecasters are beginning to factor in the impact of the delta and other variants, but in general this results in shaving off only a few decimals in economic growth estimates, which are often very large in 2021.
Meanwhile, inflation has showed up in several parts of the global economy. Mostly this has been as a result of base effects, higher energy prices, and supply bottlenecks. In some cases however, fiscal and income policies aimed at reducing inequality and increase the purchasing power of people who are less well-off (increases in minimum wages, for example) could mean that inflation may prove to be more persistent than currently thought.
As a result, central banks in EMs have already started to tighten their policy stance. Even in the G10 countries economic thinking within policy committees is now shifting. The first banks to move have been the Bank of Canada (with a tapering of its net asset purchases) and Norges Bank(which has pre-announced a rate increase in September). In both cases, the domestic economies of these countries benefited from higher oil prices. The Reserve Bank of Australia has also tapered its weekly purchases, while introducing open-ended QE. The first hints of policy normalisation are starting to emerge among the major G10 central banks too, ahead of the annual summit at Jackson Hole which will be held on August 26-28. In the past, many central bankers used this forum to announce major policy shifts.
The world’s four largest central banks are divided in this case, however. The European Central Bank and the Bank of Japan are still exhibiting a strong easing bias; their next moves may be to provide more, rather than less, accommodation.
The US Federal Reserve and the Bank of England are moving in the opposite direction, meanwhile. In the US, Chair Powell said during the latest press conference that the FOMC has had its first “deep dive” into the size, composition and timing of its asset purchases in July. We expect more colour to be added to this in Jackson Hole, with more official hints being provided at the FOMC meetings in September and November and an official announcement of QE tapering to be made in December.
The Bank of England, while saying last week that negative rates had become part of its official toolkit, also reviewed its exit sequencing, and explicitly said that if economic conditions were to evolve in line with the MPC forecasts, a modest amount of tightening would be then warranted over the next few years.
Markets seem content with these developments. Keeping inflation in check will keep bond and equity valuations up, as long-term yields that are used to discount future cash flows also remain low.
by Brunello Rosa
2 August 2021
Last week, the US Securities and Exchange Commission (SEC) ruled that Chinese groups would be subject to stricter controls and disclosures over their structures and ties to the Chinese state before being allowed to list shares in the US. This is only the latest example of the ongoing tensions between the US and China. The two world super-powers are engaging in intense competition in a number of areas, part of a rivalry we have previously labelled Cold War II.
As we have discussed on numerous occasions, we believe there are three dimensions of this Cold War II. One is a trade dispute, which raged during the Trump’s presidency and culminated in the Phase 1 deal of January 15th, 2020. Another is a technological race, in which both countries are trying to prevail in the spheres of big data, artificial intelligence and cyberwarfare. This has led to the ban of Huawei as a provider of 5G technology by virtually all US allies. Finally there is the disruption of global supply chains, a process which was already taking place before the pandemic and now is a well-established phenomenon, causing bottlenecks that have been the origin of the recent rise of inflation around the globe.
The Covid pandemic, and the arrival of the less confrontational Joe Biden to the US presidency have not led to a rapprochement between China and the US. In fact, because of the allegations made by the US and its allies (chiefly Australia) to China regarding the origin of Covid, and because of China’s repression of Hong Kong protests, there will likely be further tension occurring between China and the US.
Given this background, R&R decided to dig further into how Cold World II is impacting the three main actors of the global economy (namely, the US, China and Europe), by publishing a series of articles in John Hulsman’s Geopolitical Corner.
In the first article, titled “After the Party: How China Is Planning To Become The World’s Dominant Power” we discuss how China sees itself today - 2021 being the 100th anniversary of the Chinese Communist Party, which was celebrated in China on July 1 - and how its leadership is planning to project the country’s geopolitical influence in the future.
For China, the first geo-strategic goal is to break out of the straitjacket that is preventing the country from developing a naval dominance similar to that of the US.
Unlike the US, which is unconstrained in projecting its naval military capabilities, China immediately encounters hostile waters to its east and south, guarded by Japan, South Korea, Taiwan, and the Philippines, all of which are close allies of the US. We believe that for China, the path of least resistance in this regard will be working hard to promote the re-annexation of Taiwan, however long, gradual and complex the process of doing so may be.
In the second article, titled “The Great Sea Change: Rightfully Changing American Perceptions Of China Made The New Cold War Almost Inevitable”, we discuss how China has moved from being considered a partner to a competitor, and eventually to being declared a strategic rival of the US. This required the US political elite, Republican and Democrat, to overcome the doctrine (by Barrington Moore) according to which China would democratise while getting richer (i.e. would follow the path of Western countries, whose bourgeoisie wanted more political power as it got richer). This doctrine had long permeated the US political leadership on both sides of the aisle.
In the third article of the series, which we will publish shortly, we will analyse how Europe will figure between the two geopolitical superpowers, whether it will re-establish its long-term relationship with the US or else try to find a more independent position, one that is more equidistant between the two contenders of Cold War II.
While the integration of China in the global economy is deepening, thanks in part to the gradual liberalisation of its financial system, it is clear that the US has now decided to decouple from China. As such, there is an ongoing Cold War II taking place between the two countries, a rivalry which is intensifying and is meant to last for the next few decades. We are only at the beginning of this competition.
by Brunello Rosa
26 July 2021
While many countries are re-opening their economies in sight of the summer holiday season, the rapid spread of the delta variant of Covid-19 is casting a shadow on the strength and durability of the recovery. In the UK, the July 19thFreedom Day occurred when there were 50,000 new cases per day in the country (which has now fortunately been reduced to just over 30,000 new cases per day). New daily cases, almost all linked to the delta variant, are however on the rise in many countries around the globe.
In this environment, track and trace apps are posing their own challenges. With new cases on the rise, more and more people are being “pinged” by these systems, forcing them to self-isolate. In the UK, more than 500,000 people in a weekhave been contacted and had to stay home, posing a threat to the continuity of work operations. For example, around the time of Freedom Day, UK Health Secretary Javidtested positive to Covid, and PM Johnson and Chancellor Sunak both started to self-isolate.
In previous columns, we discussed how central banks are reacting to this increased uncertainty. Last week, the ECB decided to keep the tap of its accommodation wide open for the foreseeable future, especially as the recovery is still fragile and uneven among the various Eurozone countries. Previously the Reserve Bank of Australia (RBA) decided to move to open-ended QE, while reducing the weekly pace of its asset purchases. This week, the US Federal Reserve will reveal how advanced the discussion is within the FOMC with regard to tapering its asset purchases. Only the Bank of Canada (BoC) has continued its progression towards a reduction of its accommodation, which could lead to the end of net asset purchases by December 2021.
Within this context, governments are making an additional push to foster their vaccination campaigns. Countries such as Canada, the UK and Spain have already more than 50% of their populations fully vaccinated. In Canada, more than 70% of the population has received at least one dose of the vaccine. In the UK, 88% of adult population has received at least one dose of the vaccine. The new frontier is providing a vaccine to the younger segments of the population, which have been excluded during the first phases of the campaign but are now more affected by the resurgence of the virus.
Since vaccination is not, nor can be made, obligatory (at least at this stage), governments are now introducing subtle (and not so subtle) methods to “nudge” their populations towards becoming vaccinated. Initially, perks such as free ice cream, beers, or other products were offered to people to entice them to get vaccinated. But now, more coercive measures are starting to be introduced. Countries are developing “green passes” for those who received at least one dose of the vaccine, or for those who recovered from Covid or tested negative in the preceding 24-48 hours.
Those passes are now being made obligatory in order to carry out some activities such as dining in restaurants, using gyms or pools, entering cinemas, or attending sports events. In Italy, with a law decree, the government has imposed such an obligation as of August 6th. In the UK, the government is considering the idea of allowing attendance to large events to fully vaccinated people only. Some people are rallying in opposition to these decisions, protesting against what they perceive as a violation of their civil liberties.
In effect, some of the restrictions introduced by governments around the world have been considered unlawful or unconstitutional by various courts. Making vaccination, or green passes, mandatory, could also fall into the same category, unless constitutional amendments are made. At the same time, as we discussed in previous articles, there is a difficult balancing act governments must pursue. They need to respect civil liberties, protect public health and keep the economy running at the same time. In all honesty, this is not an easy balance to achieve.
by Brunello Rosa
19 July 2021
Last week, the countries belonging to the oil-producing cartel OPEC+ (the “+” refers to Russia and Kazakhstan, which are not in OPEC proper) decided to increase oil production by 400,000 barrels a day, in response to the surge in oil prices that has occurred in the past 15 months. In April 2020, oil prices turned negative for the first time in history, as storage costs soared in the middle of the first wave of the pandemic, when half of the world population was in lockdown. Since then, the price of Brent surged to $75pb, along the pick-up in economic activity in large parts of the global economy. OPEC+ also decided to increase the baseline production of oil in many countries, signalling that the cartel believes the recovery will continue and that higher production will be a persistent phenomenon, rather than a transitory one.
The increase in oil prices has led to a marked increase in headline inflation prints around the globe, sparking fears of incipient hyper-inflation, fears which are likely to be overblown. Most central banks have reacted calmly to the sudden rise in inflation prints, reassuring markets that policy rates will remain low for longer, and that short periods of moderately above-target inflation will be tolerated. This explains the fall in long-term yields observed in the US and elsewhere, which has puzzled investors.
While central banks have reassured markets that they will be tolerant against above-target inflation, they have also changed their policy frameworks to start addressing the impact of climate change on financially sensitive matters. The Bank of Japan has recently launched a “green-lending” scheme, set to last at least 10 years, in which banks receive central bank financing at zero per cent if those funds are lent to projects aimed at reducing the impact of climate change. The ECB has included the fight against climate change among the goals of its recently released strategy review. These moves follow the Bank of England’s seminal work on central banks and climate change, championed by former governor Mark Carney.
The inclusion of climate change among the goals of central banks, though it may seem esoteric, is justified by the risks potentially deriving from extreme climate events. Tragic examples have occurred in recent days, with the floods experienced in Germany and Belgium, which have claimed hundreds of victims and caused immense economic damage. The south of Italy has also recently been hit by storms resulting in flooding, though fortunately without causing any deaths thus far. These violent floods in the middle of the summer are extremely unusual, and scientists are saying they can only be explained by climate change (as the wildfires that ravaged Canada recently).
by Brunello Rosa
12 July 2021
Many countries are now dealing with the new variant of the Coronavirus, the Delta variant, which we discussed recently. The spreading of this variant, which is already dominant in the UK and is gathering pace in the rest of the world, is following the same patterns exhibited by the original Covid-19 virus strain from Wuhan, if perhaps with slightly reduced hospitalisation and mortality rates. In spite of the rapid rise in cases in various countries, the UK government decided to lift all Covid-related restrictions by July 19, even if some scientists believe doing so could be premature.
In any case, as discussed in our previous columns, if a new wave were to emerge as a result of a further spreading of the virus, governments would have to re-introduce some restrictions. This would have an obvious impact on economic activity. In the EU, the latest economic forecasts exhibit a marked upward revision, as a result of the pick-up in economic activity recorded in Q2. However, if new restrictions were to be imposed, a downward revision of the estimates of economic activity would be inevitable.
Facing this uncertainty, central banks are cautiously starting to signal a measured reduction of the extraordinary accommodation they have provided since the beginning of the pandemic. But they have to perform a complex balancing act here, signalling the end of extra-easy money and yet not spooking the market into thinking that monetary stimulus will be withdrawn prematurely.
Some central banks, such as the ECB, the BOEand the Riksbank, explicitly reassured market participants that their monetary stance will remain as easy as currently they are. Conversely, other central banks have clearly signalled that they intend to start reducing the pace of accommodation. The Bank of Canada has already tapered its asset purchases from CAD 5bn a week to CAD 3bn, in successive steps, with a further reduction to 2bn expected this week. In between these cases, there are central banks which have to juggle many objectives at once. The RBA, for example, recently moved to implement open-ended QE, but it has also reduced the pace of asset purchases, and it has kept the 3y yield the April government bond as its point of reference to target, rather than using November 2021 as a reference, which would have been interpreted by the market as an intention to further extend QE.
Next week, the BoJ will unveil more details about its green-related lending program, and during the following days the ECB and the Fed will further clarify their stance, with the Fed likely making more explicit its guidance that asset purchases will likely be tapered starting from the year end or early 2022. The ECB is instead a bit behind in the cycle; it will likely reaffirm its stance until March 2022. Throughout all this, market valuations will remain supported by central bank liquidity in the G7 economies, as last week fears of slowing growth and worries that new COVID-19 variants could stall the global economic recovery prompted an equity sell-off and pushed down longer-term US Treasuries.
by Brunello Rosa
5 July 2021
Last week, we discussed about the so-called Delta variant of the SARS-Covid-2 virus, which is causing a new wave of restrictions being imposed by countries, such as the UK, Australia and India. But even when countries reopen almost fully their domestic economy, they tend to keep severe restrictions to international travels. So most countries are adopting a dangerously autarchic model of domestic reopening and international closure. The reasoning behind this model is that banning virtually all international travels prevents the virus from spreading over the globe.
However, this is proving to be an illusion: travels are still allowed for business, diplomatic and related reasons. So, the virus still goes around the globe one way or the other. So one wonders why, after the virus has become pandemic one and a half years ago, restrictions to international travels are still so severe: the US only allows US citizens to land on its soil; until recently, the UK considered travels for leisure illegal and still has the vast majority of other countries in the so-called “amber list” (requiring 10 days of quarantine on arrival); after the discovery of the delta variant, most EU countries have reimposed quarantine periods for people arriving from the UK.
As discussed in our in-depth analysis on the need to balance the economic and healthcare risks, we are in favour of all sensible restrictions that prevent the virus from spreading and the pandemic from claiming more victims, but wonder whether there are ulterior motives for keeping, introducing or re-introducing quarantine periods for travellers. The EASA/ECDC already in December 2020 urged governments to abolish quarantines given their ineffectiveness. The UK authorities have found that only 0.5% of passengers returning from amber list countries test positive to Covid after two days from arrival. This evidence derives from the fact that passengers are required to test negative before flying, so the likelihood of being infected with Covid at the time of travel is limited.
We suspect there is an opportunistic use of quarantine periods deriving from political motives. Most countries want to make sure that their citizens spend the money accumulate during the pandemic domestically rather than abroad. For example, internal travels in the US are booming while international travels are still restricted. In the UK, the government is trying to encourage people to spend their summer holidays in the country rather than flying to the popular holiday destinations in Spain, Italy and Greece. For this reason, most of these popular destinations are still in amber list.
Italy has just introduced a bizarre form of quarantine: if a traveller spends less than 120 hours in the country for work reason, it does not need to quarantine. If it spends more than 120 hours it needs to quarantine immediately (when the two types of travellers clearly bare the same healthcare risk). Even more ironically, if a traveller thought it will spend less than 120 hours and ends up spending more, it will have to start quarantining at the 120th hour (after having toured the entire country, potentially).
This new wave of quarantines is intertwined with the discussion on the opportunity for the UK to host the final of the Euro 2020 football tournament, with 60,000 people expected at the stadium. Germany’s Merkel and Italy’s Draghi have already spoken about the possibility of choosing a new location, but British PM is fiercely defending the initial choice.
The conclusion that seems to emerge from this discussion is that, while the effectiveness of quarantines is questionable in this phase of the pandemic, their main motivation is political, with countries retaliating against other countries’ decision. In our view, this is hardly an effective wave of defeating the virus and its new variants.
by Brunello Rosa
28 June 2021
During the last few weeks a new mutation of the Covid-19 virus has emerged, the so-called Delta variant, previously known as Indian variant since it was first isolated in India. This has come after the Alpha variant (first isolated in Kent, in Britain), Beta variant (South African) and Gamma variant (Brazilian), as documented by the World Health Organization. As the prestigious scientific journal Nature says, “Delta seems to be around 60% more transmissible than the already highly infectious Alpha variant (also called B.1.1.7) identified in the United Kingdom in late 2020.”
It is not yet clear whether the new variant, apart from being more infectious, is also more deadly. The first indications suggest it is not more deadly, but one cannot rule out the possibility that it is just yet. For now, it seems that new infections are not leading to as many hospitalisations as during the first wave of the pandemic, but more data is needed before reaching a definite conclusion.
As a result of the Delta variant’s high infectiousness, the number of new Covid cases has been increasing in a number of countries around the globe. In the UK, for example, new Covid cases have reached 18,000 on a daily basis, after having collapsed in the last few months as a result of the successful vaccination campaign. This has convinced the government to postpone the end of the Covid-related restrictions from June 21 to July 19, and there is no guarantee that a further push back will not be needed.
In Australia, the government has imposed two weeks of lockdown in Sydney, given the rapid rise in new Covid cases related to the variant. This is also due to the sluggishness of the vaccination campaign, which led to only 3% of the population having obtained both inoculations of the vaccine. In Portugal, the government has introduced new restrictions in the Lisbon area and the Tago valley. In Israel, the use of face-covering masks in closed places has been re-introduced. In India, the state of Maharashtra has re-introduced new restrictions.
These examples show how insidious the Covid virus is. Its mutations risk rendering vaccination campaigns less effective, even as it is not yet clear whether or not a new jab will be needed to neutralise this variant. In any case, yearly vaccinations are likely to be the norm in the next few years.
As we have discussed endlessly in the last few months, any healthcare development tends to have immediate economic repercussions. Most countries were just beginning their re-opening phases, and the new Delta variant risk derailing those plans. At the same time, economic recovery is linked to the re-opening of countries. As we have seen in Q3 2020 and in Q2 2021, a bounce back in economic activity can only occur if restrictions are lifted or at least drastically reduced.
So the real risk of this Delta variant is that the planned re-opening of various countries will be severely slowed down or even go into reverse, until it will become clearer how dangerous this new mutation is. This risks stalling the nascent economic recovery, and so may force policymakers to provide more stimulus (monetary and fiscal) for longer than they otherwise would, with obvious implications for asset prices.
by Brunello Rosa
21 June 2021
As the Covid-19 pandemic hit in 2020, a synchronous wave of monetary easing took place in the world. Whether or not the pandemic would prove to have a negative effect on aggregate supply (as in fact did occur, as supply was constrained by lockdowns and severe restrictions), there was certainly a shock to aggregate demand, which needed to be supported by coordinated fiscal and monetary accommodation. In both DMs and EMs, central banks adopted a mix of policy rate cuts, asset purchases (in this case also by EM central banks), various forms of forward guidance, and credit-easing measures to stem the economic downturn due to the pandemic.
In the DM world, G10 central banks resorted to the various instruments that had been created during the Global Financial Crisis (GFC) of 2008-09, and expanded these instruments further (for example, the ECB’s PEPP). Most central banks have brought their policy rate to the zero-lower bound (ZLB), or even closer to the effective lower bound (ELB), if the latter was in negative territory. In the G10 space, the biggest policy innovations have been, in our opinion, the following: 1) the yield curve control (YCC) at the short end by the Reserve Bank of Australia, to reinforce an otherwise not-very-credible forward guidance; 2) the maturity extension of asset purchases, along with a reduction of the quantity purchased by the Bank of Canada; and 3) the new deposit tearing system adopted by the Bank of Japan, allowing the central bank to reduce the deposit rate further into negative territory while protecting bank profitability.
A number of central banks have also started to embrace policies accompanying the fight to limit climate change, primarily the ECB, BOE and BOJ.
In EMs, many central banks cut their policy rates to their all-time lows, to levels that have always been more typical for G10 central banks. Some of them, for example the Banks of Israel, India, and South Korea (among others) even started QE programs, in spite of the inherent risks of FX stability, loss of credibility and fiscal dominance that those programs entail.
One year later in H1 2021, with the pandemic being gradually gotten under control, central banks have to decide what to do next. In the G10 space, there are three groups of central banks. Those which have started (or have announced they will start) reducing the pace of accommodation (chiefly the Bank of Canada, which started tapering QE in April, and Norges Bank, which announced it will raise rates in September). Then there are those which are carrying out their latest round of accommodation yet are ready to start considering a reduction of their easing stance (chiefly the US Federal Reserve). Finally there are those which are still finishing their latest accommodation programs and cannot afford to start thinking about tapering, namely the ECB, BOJ, and BOE.
In EMs, a number of central banks have already started reversing their easing policies, and have raised rates. According to Reuters, there were already ten rate hikes that took place by the end of May, by central banks in countries such as Russia, Turkey, Indonesia, Brazil, and South Africa. These increases are to defend their currencies against the US dollar, which has been weak for years, and to stem inflation deriving from a rise in commodity prices and the reopening of economies.
As BoJ Governor Kuroda said during his last press conference: it is not unusual for central banks to have divergent policy stances. And from these divergences, a number of interesting trading opportunities may emerge
by Brunello Rosa
14 June 2021
During the G7 meeting in Cornwall a number of important issues were discussed, and some key decisions were made. The G7 agenda included, among other items, the adoption of a minimum corporate tax at the global level (of “at least 15%”; we discussed this issue in our previous column), a global vaccination plan that would allow a large share of the world population to be vaccinated against Covid by the end of 2022, and commitments on climate change (ahead of the crucial COP 26 conference, which will be held in Glasgow in November 2021). While each of these issues is of paramount importance, this G7 meeting is likely to be remembered as the beginning of a new relationship between the world’s major economies and democracies and China.
As we have discussed in the past, it was unrealistic to hope that after the end of the Trump’s presidency the relationship between the US and China would normalise. The US and China are at loggerheads with each other,as China is threatening the international supremacy of the incumbent super-power, the US. As Graham Allison argued, the two countries involved may be “destined for war”. In 12 out of the 16 historical cases analysed by Allison in which a rising power challenges the position of an established hegemon, the incumbent and challenger powers ended up in some form of open military conflict. In this case, the US and China are already involved in a new Cold War, which involves three fronts: a trade conflict; a technological rivalry and the breakup of historical value and supply chains. The strategic position of the US, which now views China as a strategic rival, as opposed to a partner or competitor, was always going to remain the same even after the end of the Trump’s presidency and the return of the Democrats to the White House.
Examples of this anti-Chinese stance in Cornwall abound. G7 Countries have invited South Korea, India and Australia to attend the proceedings of the conference; these three countries have recently soured their relationship with China. Additionally, President Biden has put “maximum pressure” on the G7 countries to stigmatise China’s repression of the Uyghurs in Xinjiang, as well as its actions in Hong Kong. Most importantly, the US has launched an infrastructure investment plan to counter China’s Belt and Road initiative, in an attempt to at least slow down the expansion of China’s sphere of influence in Asia, Africa and Europe.
The plan called “build back better for the world” aims at providing the countries involved with improved access to financing for low-carbon projects such as wind farms and railways. The plan wants to provide an alternative to BRI’s investment, but one that is based on democratic values and Western standards of doing business, and which does not entail saddling recipient countries with large amount of debt that is difficult to repay and creates a de-facto dependence of the country on China (such as, for example, the recent case of Montenegro).
The Europeans and Japan have been asked to gang up against China by their US ally, but are reportedly lukewarm about the extent of the American initiative. They fear jeopardising their relationship with China, which remains a key trading partner and an indispensable ally in the fight against climate change and future pandemics. Also, Biden’s plan is already facing resistance in the attempt to pass it through the US Congress. So one can imagine how difficult it could be to convince six other sovereigns states to back it up with their own domestic legislation. In any case, the US will probably get away with what they want in terms of official commitment, but what portions of this commitment will translate into actually implemented policies remains yet to be seen.