Black swans and white doves

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In the past week European and global politics, strong US growth data, mixed global macro numbers and eurozone, Chinese and Indian central bank policy have eclipsed Trump-mania.

What is perhaps more remarkable is markets’ reasonably benign, “risk-on” reaction, bar the euro’s sell-off in the wake of today’s ECB policy meeting.

One interpretation is that markets have become complacent to the risks presented by President Trump’s constellation of pseudo-policies, surging nationalism in Europe, the UK’s uncertain economic future and continued capital outflows from China.

I have a somewhat different take, namely that markets are rightly discounting some of the more extreme and perverse scenarios, including:

  1. Protectionist US policies coupled with higher US yields and a strong dollar collapsing tepid emerging market, and eventually global, economic growth;
  1. The “no” vote in the Italian referendum leading to the economic collapse of the European Union’s third largest economy;
  1. Surging European nationalism culminating in the collapse of the eurozone and/or European Union;
  1. The British government opting to sacrifice growth in exchange for a hard version of Brexit and;
  1. Capital outflows from China ultimately forcing policy-makers into accepting a Renminbi collapse and shocking a corporate sector with significant dollar-debt.

 

Global news, data and events have eclipsed Trump-mania in past week

Donald Trump has enjoyed a near-monopoly on news headlines since being elected President a month ago. But in the past week European politics, the surprise resignation of New Zealand Prime Minister John Key and Mexican central bank governor Agustín Carstens – both highly regarded, strong US growth data, mixed global macro numbers and eurozone, Chinese and Indian central bank policy, have for now eclipsed Trump-mania (see Figure 9).

What is perhaps more remarkable is markets’ reasonably benign, “risk-on” reaction, bar the euro’s sell-off in the wake of today’s ECB policy meeting. Emerging market currencies, which had stabilised against the dollar in late-November, have appreciated in the past week (see Figure 1), global yields have stabilised, global equities are within touching distance of a two-month high and European markets have on the whole taken Italy’s “no” referendum result in their stride.

Olivier Desbarres Black Swan Fig 1 and 2

One interpretation is that markets have become complacent to the risks presented by President Trump’s constellation of pseudo-policies, surging nationalism in Europe, the UK’s uncertain economic future and continued capital outflows from China which the media has focused on intensively. I have a somewhat different take, namely that markets are rightly discounting some of the more extreme and perverse scenarios, including:

  1. Protectionist US policies coupled with higher US yields and a strong dollar collapsing tepid emerging market, and eventually global, economic growth;
  1. The “no” vote in the Italian referendum leading to the economic collapse of the European Union’s third largest economy;
  1. Surging European nationalism culminating in the collapse of the eurozone and/or European Union;
  1. The British government opting to sacrifice growth in exchange for a hard version of Brexit and;
  1. Capital outflows from China ultimately forcing policy-makers into accepting a Renminbi collapse, which would shock a corporate sector with significant dollar-debt and jilt emerging market asset prices and global risk appetite (a de-facto repeat of August 2015).

I will explore the first three themes in this research note and return to themes 4 and 5 in my forthcoming pieces.

 

1. Renewed fears of collapse in global economic growth once again overdone

In the past couple of years I have played down the risk of an imminent collapse in global economic growth, pointing to the reflationary impact of years of monetary easing by the world’s major central banks (see The global growth story – cause for concern, not panic, 17 December 2014). And indeed global GDP growth bottomed out in H1 2016 at around 2.8% year-on-year and rebounded to around 2.9% yoy in Q3 2016, broadly in line with my forecast (see Global central bank easing nearing important inflexion point, 16 September 2016).

Moreover, the latest indicators, including the up-tick in global manufacturing PMI to 52.0 in October-November from 50.9 in Q3, suggest that global GDP growth may hit or even slightly exceed 3.0% yoy in Q4 2016 (see Figure 2), again broadly line with my expectations (see Be careful what you wish for, 1 November 2016).

 

Modest rebound in global GDP growth but still some (different) ammunition

This pace of growth is still modest compared to average GDP growth of 3.6% per annum in the past decade.  Moreover, the foundations of global growth could be compromised if, as I expect, developed central banks refrain from cutting policy rates further and if nationalist and protectionist policies take hold in the US and globally. However, I think there is a tendency to over-state this dual risk to global growth.

First, bar the US Federal Reserve, developed central banks are unlikely to start tightening monetary policy any time soon. The ECB’s decision today – a nine-month extension to its QE program until December 2017 with monthly bond purchases of €60bn – is a prime example of a very dovish tapering of central bank monetary policy. Ultimately the ECB has committed to another €540bn of bond purchases, rather than the €480bn which analysts had expected (a six-month extension with monthly purchases unchanged at €80bn).

Second, while the room for developed central banks to cut policy rates further and/or extend QE programs may be limited, a number of emerging central banks will next year likely revisit the possibility of rate cuts. The Reserve Bank of India left its policy rate unchanged at 6.25% on 7th December, contrary to analyst expectation of a 25bp cut. Its decision was in line with my view that “the RBI may stay on hold until market conditions stabilise” (see Fast and Furious – Market drift, 15 November 2016) but I still see scope for further rate cuts in India and Indonesia, amongst others, given still high real central bank policy rates.

Third, there is mounting evidence that governments in both developed and emerging economies are willing and able to loosen fiscal policy in a bid to compensate for the diminishing returns from monetary policy stimulus. US President Trump has committed to a significant increase in infrastructural spending and Chinese fixed investment growth, which had slowed over the summer, has picked up in recent months (see Figure 3). British Chancellor Philip Hammond announced in his mid-year October budget a £14.2bn increase in capital spending over five years, focussing on science, innovation, digital infrastructure, housing and transport (see EM currencies, Fed, French elections and UK reflation “lite”, 25 November 2016).

Olivier Desbarres Black Swan Fig 3 and 4

Trump protectionism – Bark worst than bite

US President Trump’s penchant for protectionist policies and dismantling of international trade agreements alongside a stronger dollar and rising US yields have understandably fuelled concerns about already modest growth in emerging markets saddled with dollar-denominated debt. GDP growth remains lacklustre in some of the largest emerging economies, including Brazil, Russia and South Africa. Moreover, a number of Non-Japan Asian economies, including Singapore, Thailand and Taiwan, are experiencing a growth slowdown (see EM currencies, Fed, French elections and UK reflation “lite”, 25 November 2016). The erection of US trade barriers would undoubtedly act as a headwind to these open economies.

Higher US tariffs and protectionist barriers may eventually, at the margin, stimulate the beleaguered US manufacturing sector. But there would also likely be a clear cost to the US, at least in the near and medium-term, and for that reason I ultimately expect Trump’s bark to be worst than his bite.

Greater tariffs would increase the cost of US imports of goods, which in 2015 amounted to $2.3trn or 13% of GDP, given the difficulty of substituting imported goods for domestically-produced goods in the short-run (the UK’s recent experience is telling – despite Sterling’s collapse in the past year, the trade deficit on goods and services has actually widened due to the increase in the value of imports outstripping that of exports). At the same time it would be naïve to expect the United States’ trading partners not to retaliate with protectionist measures of their own, putting a brake on US exports worth 8.5% of GDP. The net result is that global trade, which has flat-lined in the past year according to the CPB (see Figure 4), would likely go backwards and act as a drag on global growth.

So the price the US would likely have to be willing to pay is more expensive and/or weaker imports, higher imported inflation and/or weaker domestic consumption, less competitive exports and potentially weaker global demand for US goods – a tough sell to a consumer brought up on reasonably cheap imports.

 

2. Italian referendum “no” vote – an Italian challenge, not a European disaster

Italian President Matteo Renzi officially tendered his resignation yesterday in the wake of Sunday’s referendum result but European markets continue to be orderly. Specifically, the euro appreciated versus the dollar and in nominal effective exchange rate terms in the days following the referendum (see Figure 5), Italian government bond yields have fallen across the maturity curve (see Figure 6) and the share price of Italian banks has surged (albeit from historically depressed levels).

This is broadly in line with my expectation that “The worst-case-scenario advanced centres on reformist Prime Minister Renzi’s resignation, the rise to power of the euro-sceptic Five Star Movement (M5S), a jump in Italian bond yields, the fragile banking sector and economy’s collapse and Italy’s eventual exit from the eurozone and EU. But the more likely political, financial and economic outcome from a “no” vote is perhaps less dramatic, in my view […].” (see Renzi referendum frenzy – storm in a broken tea cup, 2 December 2016).

Prime Minister Renzi’s resignation may well usher in a less reform-minded technocratic government, led by a senior member of Renzi’s ruling Democratic Party, and convince President Mattarella to bring forward to next year general elections currently pencilled in for May 2018. The populist Five Star Movement (M5S), led by Beppe Grillo, is currently enjoying 30% support in opinion polls. In the event of early elections it would likely increase its number of seats in the lower house of parliament from 109, particularly if current electoral rules remain in place. But the path to the top for M5S and Beppe Grillo may not be as straightforward as currently assumed, with the Democratic Party still likely to be the largest party in the 630-seat Chamber of Deputies.

The Italian banking sector, riddled with bad-loans and planning a recapitalisation of its balance-sheet, can ill afford the negative press a “no” vote brings. But both Italian and eurozone policy-makers have a strong incentive to shore up Italian banks and the economy, even if posturing may precede an eventual solution. Finally, while the future of the eurozone and EU has been written off many times, I don’t envisage Italy being the trigger for a break-up of either.

 

3. Rising nationalism in Europe is wake-up call, not a revolution

Only tell time will tell whether and how fast nationalist parties in Western Europe rise to the upper echelons of power, but I would argue that there is currently a tendency to over-estimate their reach and certainly their ability to dismantle the eurozone and/or EU. Put differently, by end-2018, the political landscape in West Europe may not have changed as dramatically as commentators anticipate, with the traditional old guard still largely in place, including in Germany, France, Sweden and Austria.

 

European nationalism riding a powerful wave

There is little doubt that nationalism and populist parties have been in the ascendancy in Western Europe in recent years[1]. They have performed well in EU Parliamentary elections, in regional elections (e.g. Front National in France) and State elections (e.g. Alternative for Germany) and their ratings are going up in opinion polls. In Greece, where the economic dislocation has been the greatest, the Coalition of the Radical Left (Syriza) is already in power (see Figure 7). In Finland, the Finnish Party is a member of a three-party ruling coalition and in Denmark the Danish People’s Party officially supports the three-party coalition which gives it a degree of indirect influence.

Left-wing and right-wing nationalist parties are more effectively channelling popular discontent against the political and status quo and increasingly influencing the direction of domestic policy. As a result, traditional centrist or right-leaning parties have had little choice but to take this message on board in order to remain politically relevant and increase their chances of re-election. For example, the ruling Conservative Party in the UK has partly assimilated the anti-immigration rhetoric which is a cornerstone of the nationalist UK Independence Party (UKIP). The Republican candidate for next year’s French presidential elections, François Fillon, has traditionally adopted a conservative social and economic stance but has more recently incorporated a more nationalist bias. Even German Chancellor Merkel has had to backtrack on her pledge to allow up to one million immigrants per annum into Germany.

Moreover, Trump’s victory in the November US presidential elections and the British electorate’s vote in June in favour of the UK leaving the EU have clearly reinvigorated nationalist parties and their belief that they can tap voters which have historically supported more traditional parties and politicians.

Olivier Desbarres Black Swan Fig 7

Influence is not the same as true power

But, beyond Greece and Finland, which account for only 2.5% of the European Union’s GDP, nationalist parties in Western Europe are still in opposition and often have only a small share of parliamentary seats (see Figure 8). Ultimately they will only be able to shape the future of their countries and potentially the eurozone and/or EU if they have true power, by holding a parliamentary majority, the presidency or both.

Even Syriza is seven seats short of a parliamentary majority while the Finnish Party only has 37 out of 200 seats in the Eduskunta. In other West European countries, no nationalist party currently has more than 22% of the seats in their lower houses of parliament. In Germany, UK and France, which in aggregate account for half of the EU’s GDP – nationalist parties currently have only 3 seats out of 1,857 in the three lower houses of parliament. In Germany and Sweden, nationalist parties are still very much fringe political forces with no state-level representation and only modest regional-level representation. Moreover, none of the nationalist parties in Western Europe currently occupy the presidency. The Austrian Freedom Party’s candidate, Norbert Hofer, got close but lost last weekend’s presidential elections.

Olivier Desbarres Black Swan Fig 8

The seemingly broad-based assumption is that these parties will ultimately gain power and lead the dissolution of the eurozone and/or the European Union. Nationalist parties will admittedly in all likelihood increase their number of seats at elections for the lower houses of parliament in 2017-2018 in the Netherlands, France, Germany, Italy, Sweden and Austria.

 

Nationalist parties will grow stronger but may struggle to become major political forces

However, based on recent polls, these parties, with the exception of the Freedom Party in Austria and potentially the Five Star Movement in Italy, are very unlikely to win the largest number of seats let alone secure parliamentary majorities. For example, Alternative for Germany is a minor political force and while its anti-immigration policies are starting to resonate, it does not present a credible challenge to the incumbent CDU-CSU coalition and Chancellor Merkel. At best, some of these European nationalist parties may govern as part of broader coalitions and thus have to potentially dilute their more extreme policies.

There are number of reasons why these nationalist parties may struggle to become the major political force. First, in many countries the electoral voting systems for the lower houses of parliament include thresholds and multiple rounds of voting which work against these smaller parties securing a significant number of seats.

Second, many of these smaller nationalist parties still do not have the political infrastructure in place at a national level, financing or depth of personnel to effectively challenge the bigger parties. The messy and reputation-sapping election of the relatively unknown Paul Nuttall as UKIP leader, following Nigel Farage’s recent resignation, is a point in hand.

Third, voters are clearly rebelling against well-entrenched political players but may not always have fresh faces to elect. In the US they elected an untested businessman with no political experience as President and in Italy the increasingly popular leader of M5S, Beppe Grillo, is a former comedian. However, in France for example, the two candidates most likely to compete in the second round of the French Presidential elections next May are François Fillon – the Republican’s candidate and a former Prime Minister – and Marine Le Pen who joined the Front National 30 years ago. They are both old-school politicians who do not present a true break with the past.

Fourth, traditional centrist and centre-right parties are adapting to the new political, social and economic realities which they face and are unlikely to go down without a fight. They will have also learnt valuable lessons in the past 18 months, including the risk of calling a referendum. The demise of British Prime Minister Cameron and Italian Prime Minister Renzi following unsuccessful referendums will likely have made other EU leaders fearful of going down a similar route or of calling early elections. In particular, the ruling Conservative Party’s loss in the recent Richmond by-election has likely reduced the probability of Prime Minister Theresa May pushing for general elections, due in 2020, to be brought forward.

Finally, while electorates are clearly using their votes to express their dissatisfaction with the economic and political status quo, there are still lines they seem unwilling to cross – namely the appointment of extreme-right candidates to the highest echelons of power (the recent Austrian presidential election is a good example). Europe’s history arguably acts as stark reminder of the implications of electing a far-right leader.

Similarly, leaders of nationalist parties are still very unlikely to win presidential elections. Specifically, Front National leader Marine Le Pen would most likely lose a head-to-head vote against François Fillon in the French presidential elections, assuming she even made it to the second round. As I argued in EM currencies, Fed, French elections and UK reflation “lite” (25 November 2016) it is probably too early to rule out the winner of the Socialist Party primaries, most likely Prime Minister Manuel Valls, making it to the second round of the elections ahead of Le Pen. While the Socialist Party is clearly in disarray, Valls is more popular than President Hollande who ruled himself out as a candidate for the presidential elections.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.


[1] Admittedly the characteristics which define a party as nationalist and/or populist and left-wing or right-wing are somewhat subjective, with some parties (e.g. Five Star Movement in Italy) rejecting such labelling.

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