Author: admin@hottinger.co.uk

By Economic Strategist, Hottinger Investment Management  

A few years ago, the management consulting firm McKinsey produced a striking graphic. It showed how the economic centre of gravity has shifted over the millennia. In AD 1, the place to be was Asia. China and India produced about 70% of world GDP, with the rest shared by the Ancient world (Greece, Egypt, Turkey and Iran), Europe and Africa. That centre of gravity only really started to move in the 1500s, after the Black Death had transformed Europe’s social and economic institutions. By WW2 it was at its most westerly point, between Western Europe and the United States, as those two places accounted for 70% of world GDP. By 2025, McKinsey expects the world to be back to where it was in AD 1.

China and India will soon again account for the lion’s share of the world economy as the trend for countries with large, well-educated populations with strong governance systems to dominate takes hold. The French essayist Paul Valery was probably the first to notice this trend, writing in the aftermath of the first world war:

“So, the classification of the habitable regions of the world is becoming one in which gross material size, mere statistics and figures (e.g., population, area, raw materials) finally and alone determine the rating of the various sections of the globe.”

In the coming decades, it will make sense from an investment point of view to have an Asia-first focus, with the deliberations of the Central Bank of India and the People’s Bank of China carrying the weight that the decisions of the Federal Reserve and the European Central Bank have today. The International Monetary Fund predicts that in the next few years at least the continent of Asia will grow at 5.5% per year and account for two-thirds of all the world’s growth. By contrast, the U.S and Europe will struggle to grow faster than 2.5% per year.

It is in this context that we should see the rise in volatility in emerging markets in the last few months (see chart below). Over the last five years, there has been remarkable convergence between market volatility in the G7 and that in the emerging markets. Usually, emerging markets are attractive for investors who have long time horizons and a preference for growth over income in their portfolios, but in 2016 and 2017, according to the JP Morgan indices for volatility, emerging markets had as much average risk as that in G7 countries.

This year, emerging market volatility has risen sharply. Some of it is on the back of concerns over the fiscal sustainability of particular countries such as Turkey and Argentina; both of these countries have low levels of foreign reserves to support public debt in the event that tax revenues come up short. Similar to the situation in the United States, there is concern about over-leverage in corporate debt in some developing countries.

But much of the explanation lies with what developed-market central banks are doing with their monetary policies. The Federal Reserve has raised rates significantly in the last year, and have the intention to continue increasing rates until 2020. It is also selling Treasury bonds that it holds on its balance sheet at the time when the Trump Administration is planning to run $1trn annual budget deficits, funded by sales of new bonds to the public. With US interest rates still seen as a benchmark for the global economy, all these developments mean that global yields are rising on government and corporate bonds; additionally, the supply of dollars is more limited, strengthening the dollar exchange rate and making it harder for emerging markets to service their dollar debts.

This latter explanation reflects emerging markets’ vulnerability to external factors more than fundamental unsoundness with the direction of economic policy and development. It is why in the medium-run we should still expect relatively higher volatility to be the price to pay for exposure to developing countries, and why–although we should be concerned with the big uptick in EM volatility–we should place it in its proper perspective. As emerging economies grow, they will develop policy independence and less sensitivity to global events.

It has been an eventful few weeks in Europe. Markets have been actively following the unfolding situation in Italy, as the new 5 Star-Lega coalition of populist parties took office. Things have quietened down as the members of the new government have reassured investors that it has no intention of leaving the euro, or breaking EU-mandated public spending limits that might have led to the same event.

But this is not the end of the story because there are a range of possible events stemming from Italy that could unnerve markets in the coming months and test the political foundations of the eurozone.

The bold macroeconomic policies of the new Italian government are the central issue, and will create headaches in Europe. The recently agreed 5 Star-Lega populist administration has plans to sharply increase benefits to the unemployed, radically cut taxes, reduce the retirement age, and increase infrastructure spending. Independent estimates put the increase in spending at over €100bn per year, or 6% of GDP.

Italy is not a profligate country. It has run a primary budget surplus since 1992 and only has overall budget deficits due to the interest charges on its extremely large public debts – currently around 130% of GDP. Much of that debt accrued in the 1970s and 1980s as Italy raised funds to develop its welfare state and to invest in the country’s poorer and more agricultural south through the Cassa per il Mezzogiorno programme. Interest rates also rose sharply in the 1980s as the Bank of Italy clamped down on high inflation, raising the debt burden further.

There are two short-to-medium term problems with the new government’s fiscal plans, the first exists irrespective of whether one believes bigger deficits would lead to the growth and additional tax revenues that would make the new debt sustainable. But both problems potentially lead to conflict between Italy and Europe’s creditor nations such as Germany and the Netherlands.

The first issue is both legal and political. Under the EU’s Fiscal Compact, countries cannot run a budget deficit greater than 3% of GDP, and if they insist on doing so they forfeit the right to assistance from the European Stability Mechanism in times of crisis. Being told by Europe that Italy cannot implement its economic policies is unlikely to reduce populist feeling in the country. Lega’s Matteo Salvini recently said that Italy will not be “slaves of Brussels or Berlin”, while 5-Star’s leader Luigi Di Maio suggested that he will go to “European tables” to fund his spending plans. That means either ignoring or revoking the Fiscal Compact.

The second issue is practical. Running large deficits means issuing quantities of bonds into the market at a time when the central bank is not an active player on the demand side and when interest rates are rising. Italy then would become exposed to significant political risk that could sharply push up yields further and thus the cost of borrowing. That in turn makes servicing Italy’s enormous debt pile even harder and could create centrifugal forces that make the state’s position in the euro area unsustainable. It is the feared ‘debt-crisis’ scenario.

This second issue assumes that markets believe that more state spending would not boost growth, and thus cut the debt-to-GDP ratio in the long-term; that is open for debate. But it also assumes that there are no meaningful political reforms in the euro area. Meaningful reforms include either significant moves to share risk across the region, such as introducing a Eurobond or a “safe European asset” that is backed by all euro area states; or agreeing to a banking union that consists of universal deposit insurance and a fiscal backstop for failed banks. In short, it assumes that Germany and other creditor states in Northern Europe do not agree to any form of risk sharing that ranges from debt guarantees to fully-fledged fiscal transfers.

Northern Europe and particularly Germany remain resistant. Last month, over 150 ordo-liberal German economists warned in a public letter against what they called a “debt union,” which would mean German taxpayers implicitly supporting other states. Chancellor Angela Merkel wants only limited reforms, including a European Monetary Fund that restructures debt and gives loaned assistance only if there are Eurozone-wide systemic risks and recipient countries implement structural reforms. This means exposing investors in troubled states’ bonds to haircuts and lengthened maturities during times of stress.

Unfortunately the German proposals, supported by the Netherlands and Austria, as they stand serve only to crystallise all of the problems that arose from the euro crisis of 2011-15. Merkel’s debt restructuring plan would weaken private sector confidence in peripheral sovereign bonds and reopen the possibility of self-fulfilling fiscal crises. It enacts punishing and self-defeating austerity regimes on troubled debtors, and strengthens the position of German Bunds as a safe asset. Italy will want a bolder approach, and they are likely to push for that ahead of the next EU summit on June 19th. France too will expect bigger concessions after implementing domestic reforms in labour markets and public spending as a quid-pro-quo for more economic integration.

The risk of a future Italian debt crisis also assumes that the ECB will not continue to backstop Italy’s sovereign bonds. This happens by default if the bank eventually moves into a phase of shrinking its balance sheet, but if the next governor of the bank, who takes office in October 2019, takes a more hawkish point of view, as is the preference of the German government, support for Southern European sovereign bonds in a future crisis scenario may not be there. Considering that it was Mario Draghi’s commitment in 2012 to do “whatever it takes” to contain the last crisis, a reversal of that commitment would create clear dangers.

We therefore face the possibility that the political ambitions of Italy’s new government could be thwarted by other countries and the European institutions. The question then becomes whether the populist government could credibly threaten to leave the euro and throw Europe into turmoil to extract concessions from the other countries. The answer is probably ‘no’ as euro-exit would decimate the Italian middle class. However, the systemic importance of Italy in the euro area and the recent shock of Brexit should focus policymakers.

Events in Europe in the last month show that there are still significant tensions between member states that cannot be solved by a short-term burst in economic growth across the region. Yet as that growth starts to slow and the ECB tightens policy, conditions will not be more favourable than they are today to agree the necessary reforms.

What is needed is a greater sense of pan-European solidarity in which your typical German Bavarian thinks of the concerns of the Italian Neapolitan with the same empathy with which she considers the problems of her immediate compatriots. That’s a multi-generational project.  In the absence of that, Europe will continue to evolve through crisis, yet always carrying with it the tail risk of breakup. Political risk in the region has clearly not gone away.

The consensus view in markets is that the United States is in the late stage of its economy cycle, that it is very close to full employment and that inflation will accelerate this year. On the back of this, many expect that the Federal Reserve – anticipating an overheating economy – will raise interest rates multiple times this year and scale back their asset purchases.

But what if this view is wrong? While we do see signs that indicate inflationary pressures in the US–from lagged PMI trends and capacity utilisation figures – we have repeatedly pointed out that unemployment is a misleading indicator of tightness in the US labour market. This is because the measure is blind to the large volumes of people who left the labour force after the Great Recession of 2007-9 and who are now returning. Official unemployment is a measure for only those people who are in the labour force at any given point in time but do not have a job.

This is the position that Martin Sandbu at the Financial Times (£) takes yesterday, and it can best be illustrated in the chart below.

Sandbu’s basic idea is that it is possible for the US economy to continue hiring people but for wages to remain muted as more people return to the labour market. We can see in the chart above that labour force participation – the proportion in the population of 25-54 year olds which takes part in the jobs market – is still well below its 1990s-peak, while the employment rate – the proportion of the population that has a job – is below its cyclical peaks in 2001 and 2007. The message, Sandbu concludes, is that there is still spare capacity in the US economy even though unemployment is low; and wage (and price) inflation is subdued because both employment and labour force participation are rising.

How likely is this? There is reason for doubt. Unemployment among 25-54 year-olds as a proportion of the population, implied by the gap between labour force participation and the employment rate in the chart, is also near the cyclical lows of 2001 and 2007. This is not the official measure of unemployment, which measures the proportion of the labour force that is unemployed, as opposed to the proportion of the population. However, official unemployment is also at similar cyclical lows. In both 2001 and 2007 for both measures, unemployment turned upwards within twelve months of peaking. This behaviour can be seen in the chart below at the peak of almost every economic cycle in the US since 1948. The only exceptions are in the late 1950s and late 1960s, when unemployment held steady as the economy added new jobs.

The question then is: which is the better cyclical predictor for labour market tightness – employment or unemployment? While Sandbu’s argument for the employment rate is plausible, it implicitly assumes that the damage wrought by the Great Recession can be largely if not fully unwound. On that point, we are sceptical.

There is evidence that during recessions, firms are more likely not just to fire workers but replace them with technology. Technological change has made large numbers of middle-aged Blue Collar men redundant. 90% of jobs in clothing manufacturing and 40% of jobs in electronics in the US have disappeared since 1990. Indeed, the labour force participation rate itself has been trending down since 2000. These jobs are not coming back and for many of the workers who are affected it is not possible technically or mentally to reskill. The scale of the opioid crisis points to the despair that many of these people feel with regards to their situation.

We don’t know what the scale of the damage has been, but there is good reason to believe that the labour force will not reach the size it did in the late 1990s. This doesn’t mean that labour force participation cannot continue rising in the short-term, delaying inflationary pressures; or that we should not pay attention to other measures of labour market tightness such as employment. But Sandbu’s implicit suggestion that, because employment remains low compared to the last 20 years, the US is necessarily still far from full employment is too easy. It is possible that the US economy has exhausted the gains from increased labour force participation, meaning that employment cannot continue to rise without pushing down unemployment, which is at cyclical lows. And this would most likely be inflationary.

We still therefore expect wage and price inflation to pick up this year as the US labour market tightens, but we would not be surprised if the process takes a bit longer than it does under the consensus view, with signs manifesting only during H2 2018. The Trump Administration’s fiscal stimulus program will, however, act only to hasten inflation’s arrival.

Much has been made of how the recent wage data coming from the US was the cause of the correction we saw in asset markets last week. It suggested that the Phillips curve may finally be asserting itself at a time when producer and commodity prices have been rising and the temporary factors cited by the Federal Reserve as holding inflation back are easing.

However, a bigger risk is that inflationary pressures are building in the euro area. The ECB has engineered a huge export of capital from Europe to the United States with its programme of asset purchases since 2016. The ECB’s bond buying programme pushed European yields down and encouraged investors to ‘search for yield’ in relatively more mature US markets that offered higher returns.

Markets got jittery in January after the release of the minutes of the ECB’s Governing Council most recent meeting, indicating that inflation may come through sooner than expected and that the central bank was willing to change its language with regard to its future policies. Investors up until then more or less believed Mario Draghi’s commitment to easy policy for as long as necessary to support the euro area’s recovery and the convergence of inflation towards the bank’s 2.0% target. Very little activity on rates is priced in.

However, there are good reasons to believe that inflation will pick up this year in Europe. Since 2014, capacity utilisation, a measure of the degree to which firms are using their resources, has been creeping up. Part of this reflected the low level of capital expenditure in the bloc and weak bank lending. The acceleration in EZ growth in 2017 caught a lot of manufacturers by surprise, with many increasing capex spending. Imports into the euro area in the year to November 2017 grew by over 7%, with the largest increases in import volumes in machinery from capital goods exporters such as China and South Korea, as well as in energy from Russia.

Nevertheless, capacity remains constrained and inflation is currently much lower than it should be as suggested by the level of utilisation (see chart below). It certainly has the potential to break through the 2% target-level within the next 12 months.

The other indicator that points to a pick-up in inflation is the level of unemployment. It is easy to be deceived by the European jobs market. In most Anglo-Saxon countries, unemployment typically has to fall below 5% before signs of price pressures emerge.

Anglo-Saxon economies tend to have more flexible labour markets that support people who have generalist skills. This means firms tend to report shortages when most people who want a job already have one.

In continental Europe, employment is typically more exclusive. To break into many parts of the French, Italian and German labour market, workers typically need to have specialist skills that cannot be easily transferred to other occupations and require years of training to acquire. Further, the costs of employing workers are typically higher due to taxes and regulation, which encourage firms to substitute workers for machines. Higher rates of unionisation can protect insiders at the expense of outsiders. And more recently, the scale and length of the euro crisis have increased the long-term unemployment of young people. All these factors mean that firms across the EZ are reporting skill shortages despite headline figures of unemployment of around 8.5%.

As the chart below shows, there is a relatively tight relationship between trends in HICP CPI inflation, which the ECB targets through its policies, and the level of unemployment six months prior. It shows that inflation starts to accelerate when unemployment falls below 8.5%, roughly where it is today. It also suggests that based on the steady reductions in unemployment since 2013, inflation is likely to pick up later this year. It is not out of the question that it could break through the ECB’s inflation target.

Together then, both capacity utilisation and unemployment figures point to upward price pressures that are unlikely to be offset by the downward pressures of a stronger euro on import prices. Add to that the strong EZ-wide PMI data and we think there is a strong case for a change in the ECB’s stance in the second half of this year.

Last week’s correction was healthy for equity markets which looked overstretched. But it did little to change the extraordinary fact that more than 15% of bonds on global markets trade with negative interest rates, according to Deutsche Bank. As central banks move from quantitative easing to quantitative tightening in the second half of 2018, that situation will have to change, which would at the very least create a more unstable and volatile market environment as both bonds and equities adjust to their fair values.

Donald Trump put ‘America First’ front and centre of his pitch to business elites at the World Economic Forum in Davos last week. WEF is a club for business leaders, financiers and politicians who mostly share a suspicion of nationalism and a belief that globalisation is good. But Mr. Trump, surely knowing this, went to sell his country.

“America is open for business and we are competitive once again.” He praised his administration’s efforts in cutting taxes, slashing regulations and renegotiating trade agreements. The results, he boasted, were billions of dollars of announced investments in the United States.

However, competitiveness in international markets can also arise from a cheap currency. The US President didn’t mention this anywhere in his speech, but one had the impression that if his other policy proposals fall flat, the option of pushing down the dollar would be the last resort in his fight against so-called unfair trade.

At face value it seems that movements in the US trade balance have had little to do with the real effective exchange rate (REER) in recent times, as the chart below shows. To improve the fit of the two series, we would need to lag the real exchange rate by three years, but it’s implausible that it takes that long for businesses to react to changes in the real exchange rate.

There will never be a perfect relationship between REER and the trade balance, especially the US trade balance, for a number of reasons: because not all trade is price-sensitive; because the dollar is a safe-haven currency and the world’s reserve currency of choice; because many commodity contracts are priced and settled in dollars; and because speculation allows investors to take bets on the future path of national economies.

However, it remains the case that REER is the variable that ‘co-moves’ most closely with the trade balance. Sometimes the REER responds to the trade balance, driven by international capital flows and demand shocks; and other times it’s the trade balance that responds to changes in the REER. That said, the discrepancies of the 2000s – during which the dollar consistently fell but trade deficits grew – look rather large and need some explanation.

The 1990s saw the US boom relative to the rest of the world, with growth averaging close to 4% under Bill Clinton. It was these fundamentals that led to the dollar appreciating strongly during the decade as foreign capital flowed in, a process that accelerated immediately after the Asian Financial Crisis in 1999. The Clinton Administration also favoured a strong dollar because it kept inflation and interest rates low and put pressure on domestic producers to improve their competitiveness through investment. But it also caused the trade deficit to rise sharply.

While the dollar fell against most DM currencies after the US fell into recession in 2002, it continued to rise against currencies of key emerging economies which represented around half of US trade deficit in goods at the time. The dollar continued to rise against the Mexican Peso until 2007 and remained flat against the Chinese Renminbi until 2005, causing the trade deficit to keep rising. Mexico and China alone accounted for over 40% of America’s 2006 trade deficit.

It was largely China’s dollar-renminbi peg between 1995 and 2005 that distorted the relationship between REER and the US trade deficit after 2002. Large-scale capital export from China to the US also maintained a distended trade deficit until 2008.

Accusations of currency manipulation by the United States’ trading partners pre-date Trump by almost twenty years. In 1988, the US Congress passed the Omnibus Trade and Competitiveness Act, which called for more action to be taken against nations which were identified as fixing their currency to steal an advantage. It was only in 2005, ten years after China had begun holding the renminbi at 8.28 yuan to the dollar, that Congress’s threat of tariffs against China – on the grounds that the peg turbo-charged the US trade deficit by preventing the renminbi from rising – caused the country to abandon the policy.

In the immediate aftermath of the Global Financial Crisis, China halted its ‘managed appreciation’ and resumed its dollar peg at 6.83 yuan to the dollar for over two years, which led to new accusations of currency manipulation as the US trade balance started to tick up again.

Since the end of 2011, the dollar has rallied, benefitting from the combined effect of being the first major economy to recover from the GFC and, more latterly, being the main recipient of the ‘search for yield’ process that has followed loose monetary policies around the world. But as of yet, the trade deficit has yet to deteriorate further, although the most recent figures suggest it is rising.

Last year, the dollar lost close to 10% of its value on a trade-weighted basis and it is now common to hear talk of the dollar as now being ‘weak’. But this is not so. By recent standards, the dollar is still relatively strong, and on a short-term basis there is scope for capital repatriation from the Trump tax reforms to push the dollar up this year.

Fundamentals, however, suggest that unless the dollar falls over the medium run, and there is good reason to think it will (the return of Europe, the strength of EMs, normalisation in policy outside the US), the trade deficit should rise, and this creates a source of political risk from Donald Trump.

Trump cares about the trade deficit. He thinks that a large deficit means that the US is somehow losing money. It is also true that his core voters – blue collar, manufacturing workers – struggle with a strong dollar. If his tax and regulatory reforms fail to bear fruit for the people that he claims to represent – with firms using the benefits of depreciation expensing to fund stock buybacks rather than capital investment – we would not be surprised if this unpredictable President turns to more drastic action on currency and trade restrictions, including managed interventions and tariffs. And that would create all kinds of problems for businesses that use international supply chains, central banks that have independent mandates and – in extremis – whole economies that depend on the rules-based international trading system.