Author: admin@hottinger.co.uk

The global economy is in fine form. Recent figures tell us that in the last year the United States grew by 3.0%, the euro area by 2.4% and China by 7.0%. Growth in almost every significant nation has outpaced market expectations. The exception for now is India, which is still struggling with the fall out of Prime Minister Modi’s demontisation policy.

Despite favourable monetary conditions, inflation is below 2% in most developed markets and below 4% in most emerging markets. This has created a benign environment for global trade; for corporates, whose rising pricing power has fed through into earnings; and for risk assets, which have benefitted from low volatility.

We are not completely convinced that this positive moment for the world economy is sustainable and we have raised concerns about the lack of productivity growth in the G7 and the financial stability risks associated with easy money. Nevertheless, we think the outlook for both developed and emerging markets over the next 2 years looks relatively positive.

If productivity continues to disappoint, inflation will start to rise. If money stays easy for too long, financial stability tends to weaken, a particular concern of the Bank of International Settlements. A key question therefore for both economists and investors is – as ever – if, when and by how much will central banks raise interest rates. Central banks have a responsibility to manage both inflation and general financial conditions.

There are two different issues here. One relates to the nominal interest rate; the other refers to the real interest rate. Nominal interest rates remain in an exceptional place. Policy rates in Europe, Japan and the US are below 1.5%. Sukanto Chanda at Deutsche Bank has assessed the $8trn global credit market and finds that 17% of all sovereign and credit debt trades at negative interest rates. These positions depend almost entirely on central bankers’ monetary policies and are likely to reverse as soon as banks embark on a sustained course of balance sheet and policy normalisation.

But this leaves the question of how high interest rates need to go to complete the process of normalisation. To get to an answer, we need to know what the risk-free real interest rate consistent with full employment is, as this reflects the underlying balance of supply and demand in credit markets.

A study in 2014 by former Bank of England Governor Mervyn King and David Low was the first that attempts to estimate the ‘global risk-free interest rate’. They use 10-year inflation indexed government bonds across developed nations as a proxy and find that yields have fallen by about 450 basis points since 1987 and are close to 0%. What this means is that developed economies that are neutral on monetary stimulus require nominal yields to rise to around 2-3%. Since many state bonds are not far off, this suggests that the amount of further tightening required from banks is limited.

The drivers of this multi-decade shift are numerous and relate to both the global desire to save (which has gone up) and the demand for credit (which has gone down). This means that global investment as a share of GDP has remained relatively constant over the period despite a large fall in the cost of credit.

The three supply-side factors that have increased the desire to save include: (1) reductions in the dependency ratio; (2) the creation of a savings glut from emerging economies in Asia, and more recently Northern Europe; and (3) rising inequality, as wealthier people save a greater fraction of their income.

On the demand-side, pessimistic expectations for innovation and productivity growth have cooled demand for credit. The falling price of capital also means that businesses need to spend less to meet their production needs.

So if low rates are the new normal, we have to revise our outlook for expected returns for risk assets. If new innovations are not forthcoming and more global capital chases fewer investment opportunities, returns are likely to stay low.

There are risks to policy too. Low rates and volatility will encourage ‘searching for yield’ – that may lead to problems for financial stability down the road.

Additionally, if central banks are committed to low inflation targets, there is much less they can do to stimulate the economy in the event of another recession. Nominal interest rates cannot credibly be held much below 0%, so banks will either need to rely more on unconventional measures such as QE or raise their inflation targets. It also means fiscal policy will be more important in turning around depressed economies.

With real interest rates at close to 0%, the bar for fiscal expansion is effectively lower as debt interest costs become almost a non-issue. The question in the future will increasingly be: does extra spending create at least as much in GDP? And the answer will almost always be yes.

Changes in the global economy in the last thirty years have reshaped the landscape for markets and policy. Today, both markets and policy are in new, unchartered territory. This need not be a bad thing, but the uncertainty puts additional responsibility on the industry to look out for known unknowns and be ready to respond to any unknown unknowns.

It’s an interesting time to observe the UK property market. Uncertainty over the country’s economic and political future comes at the same time as an uptick in global growth, driven by Europe and Asia. With these factors pushing in opposite directions, it shouldn’t be surprising that the current outlook for the property market looks mixed.

UK commercial property

The UK investment volume for H1 2017 was £27.2 billion, which is 1% higher than the same period in 2016. London accounted for 50%. Low levels of investment stock are pushing prices higher. After a spike after the EU referendum, prime rental yields across sectors have fallen back to pre-Brexit levels. The differential between prime and average yields is close to their 180 basis-point 10-year average.

According to the latest RICS survey for Q3, demand for industrial and office use was up over the quarter, but for secondary retail demand was down significantly. Surveyors believe that UK-wide industrials look most likely to secure growth in capital value and rental income over the next 12 months. Non-prime retail looks weak across the UK. Prime office and retail are strong with the exception of London, which 67% of respondents say is overvalued. Despite concerns over London, 3-in-4 surveyors believe the UK market as a whole is fairly-valued, and up to half think the market is still in its upturn phase.

The UK student housing market has also been robust since the Brexit vote. 2016 saw the second highest ever investment volume into purpose built student housing with £4.5bn ploughed into the sector. The combined effect of the weaker pound, the UK’s strong reputation in higher education, and the government’s clarification on the fees and living status of EU applicants has eased concerns.  Investors still see student housing as a source of stable and reliable income.

However, there are concerns over data from the construction industry, which fell into recession in Q3 2017. IHS Markit says that the combination of continued uncertainty over Brexit negotiations and fears of higher interest rates has delayed or discouraged new commercial and residential projects.

While sterling has recovered as the economic effects of Brexit have proven to be weaker than expected so far, there are downside risks. Fundamentally, Brexit put a discount on the UK economy of around 10-25% in terms of currency depending on the deal that is eventually struck. This centres new sterling’s long-run value to 1.30$/£ and 1.1 €/£. In the short-term, a weakening of the British economy will push the currency down, but the main worry is the non-trivial risk that Britain leaves the EU without a deal. However, if the government succeeds in maintaining many of the economic benefits of EU membership, the post-vote effects on the currency and the wider economy can be largely reversed.

The Bank of England is likely to raise interest rates in November, with effects already priced into sterling. But if the Bank moves onto a path of further interest rate rises, downward pressure on property prices can be expected if the spread of property yields over government bonds is maintained. This pound will strengthen if interest rates rise without significantly weakening growth.

UK residential property

In the residential market, a clear division can be seen between the performance in London and the rest of the UK. Since 2014, prices for homes valued over £1m in Central London have fallen by 15.2%. The rise in stamp duty land tax by 300 basis points in 2016 to 15% for homes valued above £1.5m is cited as a major reason for the downturn. However, according to Savills, there has been little change in the number of transactions of £1m+ properties in London since the 2014 market peak. Brexit uncertainty is more likely to be a factor as is the growing attraction of other world cities such as Sydney, Toronto and Stockholm. But rental yields point to the key driver. In West London, yields are below 3%, indicating an overvalued market for ownership that cannot be supported by local incomes. Further price falls in 2018 are probable.

The rest of the UK residential property market is in better shape, with year-on-year price growth in October at 2.5% according to Nationwide. Some areas still offer attractive returns to buy-to-let investors. Towns and cities in the South East such as Luton, Colchester and Peterborough offer yields between 4-5%, double-digit capital gains, and strong rental price growth. The North-West region and Wales report strong price and yield growth, with Manchester and Salford doing particularly well. Manchester remains the UK government’s centre for its Northern Powerhouse project, while high living costs in London are pushing people to search for value in the wider commuter belt.

In summary, the UK property market looks healthy but economic and political uncertainty is keeping investors and builders cautious. Downside risks are concentrated in London, where the impacts of Brexit on commercial activity are likely to be greatest and there are concerns over affordability. The fortunes there and across the rest of the UK depend on whether the country stays open for business.

For the last 6 months, the economic narrative has turned to the idea of ‘global reflation’. Strong economic activity and rising corporate earnings have been a theme for the world economy since late last year. Consumer and investor confidence has risen in both the developed and emerging markets.

But has the recovery relied too much on loose credit? Have we learned anything from the financial crisis? It appears that we haven’t. Excess global liquidity has led to mal-investments in China. It has encouraged managers in the United States to load up on debt and buy-back stock rather than invest in their businesses.

Both the People’s Bank of China and the US Federal Reserve have raised concerns about credit and financial stability. However, the spectre of balance sheet reductions and interest rate rises at central banks in China, the euro area, Japan and the United States threatens to take liquidity out of the global system and bring reflation to a halt.

Credit has been growing at an increasing rate relative to GDP in both the US and China. The incremental benefit of additional credit has been falling. Much of that debt has been raised to fund consumption, finance existing structures (such as real estate), and refinance existing liabilities. This is also the case for the UK, where the savings rate is at an all-time low of 1.7% of GDP. With real earnings stagnant or falling for many, consumer credit is growing at a rate of 10% y/y.

In China, the ruling Communist Party has imposed lending ceilings on its banks and is taking action to restrict credit to underperforming State-Owned Enterprises (SOE) and Local Governments. While these reforms have reduced the number of units of credit to produce a unit of GDP from 5.5 to 3.9, the rate is still extremely high. According to Citigroup, credit provision in China is today half as ‘efficient’ in creating productive output than it was in just 2008. It is about 30% less efficient than it is in the United States.

That’s not to say that US financial markets have been allocating resources prudently. The country has progressively become more credit-reliant since the end of the Bretton Woods system of capital controls. The amount of credit required to drive economic growth has doubled since 1980. The Chicago Fed National Financial Conditions Index shows that a prolonged period of easy credit has existed in the US since 2012, and is similar in scale to the periods representing the dot-com bubble (1995-2001) and the housing bubble (2001-2006).

In the current cycle, according to Absolute Strategy Research, US-held debt is concentrated in companies that have high ratios of capital expenditure to sales, relatively lower levels of cash and high levels of employment. Exposed sectors include Oil & Gas, Industrial Goods and Healthcare. For the largest 500 US companies, net debt has grown faster since 2012 than before the financial crisis. As always, the risks of easy money are not confined to financial stability but extend to the real economy as a whole.

While central banks are rightly concerned with keeping credit growth under control, growing debt-to-GDP ratios have reduced tolerance for higher interest rates. A rate rise from say 1% to 2% may not sound like much, but for a company that loaded on credit at rates of 1%, such a change represents a 100% increase in financing costs. With leverage increasing, there is relatively less real activity to support higher interest expenses.

Central Banks therefore face a dilemma between maintaining financial stability and keeping the real economy strong. A further problem they face is that the performance of the global economy and the strength of demand are related not simply to the supply of credit but the acceleration of credit growth. In other words, if the rate of growth of credit growth becomes too slow, economic output and demand can suffer. The problem for the US is that despite its having easy financial conditions, credit acceleration has actually slowed and this will weigh down on demand and inflation.

The Federal Reserve is therefore caught in a bind between putting a lid on an inefficient credit market for the sake of financial stability and keeping those very lines of credit open to an increasingly addicted economy that is arguably not at full employment. Yet it is hard to believe the Fed is simply looking at what their increasingly flawed Phillips Curve models are predicting about core inflation and reacting accordingly.

That appears to be ostensibly what they are doing. Janet Yellen wants to and has started to unwind the Fed’s monetary stimulus, but she seems to be doing so under the cover that core inflation is likely to accelerate in the coming months. That might happen, but if it doesn’t, the risk going into 2018 is astonishingly that the Fed tightens conditions too prematurely. However, the relationship between interest rates and economic stability in conditions of excess liquidity is not linear, and it may be judged prudent to take some fuel out of the economy now to prevent a bigger problem — perhaps another financial crisis — later on.

Meanwhile, with China responsible for a very large part of the period of global credit acceleration since 2014, some are concerned that credit tightening in China will put strong brakes on global growth through credit markets and the inventory cycle. This certainly was the case in 2010-11 when China last squeezed the credit markets, but there is reason to believe that China is now better equipped to absorb tighter conditions. Private sector investment has replaced spending by SOEs. The labour market is tight, keeping private consumption growth high. And export growth projections are up on the back of the strong recovery in emerging markets.

Yet, similar to the US, there are risks for China in cutting credit growth too fast. Corporate debt has risen from a high 100% of GDP in 2008 to 170% last year. Clamping down too heavily on credit, in the name of making the Chinese economy healthier, could instead make things worse.

It would be too much to say that the global recovery is built on sand. Real activity is up. PMIs look good in the US and the Eurozone. Consumer confidence is growing. And while the inventory cycle has turned in Asia there is good reason to believe the correction will be small. But it is right to say that if the lesson from the Global Financial Crisis wasto reduce the role of credit in fuelling non-productive activities and of leverage in driving the business cycle, that lesson has clearly not been learned.

The mood in Europe has noticeably shifted this year as a combination of populist defeats at the ballot box and an improving economy has given rise to a feel-good factor. Unemployment, at 9.3% in May, and Q1 growth of 0.6%, suggests that the euro area, after almost seven years of stagnation, is turning the corner.

But recent developments regarding Italy’s banking system ought to give pause for thought.

The ECB is concerned about bad debt in the banking system and its concentration in Italy. And they should be. While lenders across the euro area directly supervised by the ECB are exposed to sour loans worth €915bn, or about 4 per cent of total exposure, Italian banks alone have €326bn of exposure to non-performing credit.

To attempt to address this problem the ECB recently called for banks to cover the unsecured portion of all bad debt within two years, and for all of it within seven years. This will raise the cost of holding debt for banks, as only around half of Eurozone bad debt is covered by borrowers’ collateral. The likelihood of fire-sales of NPLs risks reducing banks’ capital ratios and thus lending.  The Bank of Italy and former PM Matteo Renzi have complained that these measures threaten Italy’s fledgling recovery.

Italy’s fragmented banking system

With over 400 national and regional players, Italy’s banking sector is highly fragmented and localised. This has created a source of systemic risk in Italian banking as many of these lenders have opaque and politically-influenced lending practices, with prudence often taking a back seat.

According to ECB and IMF research, even as Italy holds a third of the eurozone’s NPLs, a much higher rate of bad debt is held in banks in the south of the country than in the north. It is alarming that the problems that have surfaced to-date – in banks such as Popolare di Vicenza, Veneto Banca and Banca Monte dei Paschi di Siena – are situated in Italy’s industrial north than in the old Bourbon states of the south, where credit allocation is more suspect. The same IMF study found that three-quarters of Italy’s NPLs are related to the corporate sector, with the construction, services and ‘less technologically intensive sectors’ most badly affected. These are typically industries that are more localised and more ‘southern’.

To understand why Italy is in such a pickle today, it is worth looking at some recent history.

After a social pact in 1993, promising to coordinate the country’s industrial, labour and financial systems, Italy had an opportunity to become a German-style economy. But these reforms were watered down and basically abandoned after Silvio Berlusconi came to power in 1994. Instead, Italy remains stuck as a state that relies heavily on the government to keep the social peace by compensating losers and strong political actors. Banks are merely one of the tools at its disposal.

Historically, Italy has had a financial system that was largely based on patient capital especially at the SME level. The country’s corporate structure is marked by ‘pyramidal ownership’ that allows families or other entities to control large parts of Italian industry with relatively small ownership stakes. Families develop long-term relationships with banks, which in theory should lead to system that is relatively stable and low-risk. However, the state has always had a great degree of influence over the allocation of capital across the financial system, and that remains despite waves of bank privatisations since 1979.

Today, politicians exert influence in Italy’s financial system through the system of ‘foundations,’ opaque, non-profit bodies that were set up in the 1990s to ensure lending remained in the ‘public interest’. Foundations own just 23% of Italian banking assets but control the boards of the country’s largest banks. In Unicredit, foundations own just 9% of stock but control 84% of seats on the Board of Directors. Almost half of foundations are elected by local authorities, and 60% of the seats on the board of Foundazione MPS and 55% at the Fondazione Cariplo (Intesa) are held by local politicians.

Italy’s banking crisis in context

But there’s a bigger problem here, and it relates to the political economy of the Eurozone. In the euro area there are two groups of economies, export-led economies in the North (such as Germany, Belgium, the Netherlands and Austria) and demand-and-credit-led economies in the South (such as Greece, Italy, Spain and Portugal).

States in the north steadily gained competitiveness vis-à-vis the South in the early 2000s by holding wages down and cutting unit labour costs through improvements in products and processes that raised productivity. Coupled with low domestic demand, particularly in Germany, this created a situation of excess savings in the euro-North (Germany) that were channelled into the euro-South (Italy) and established the trade imbalances that underpinned the first euro crisis.

Because the EU’s institutions place constraints on national economic and fiscal policy, and because member states do not have their own currency, southern states, including Italy, used their leverage on banks as a partial substitute for tools it would typically use to keep the social peace. These states were helped along by low interest rates and risk premia that were more relevant to Germany than to countries like Italy.

Credit growth, supported by capital inflows and implicit bailout guarantees, replaced fiscal management as an engine powering domestic demand growth in the euro-South. It also turbo-charged imports of the high value-added goods from the North that countries in the South did not produce itself, leading to large trade deficits. German credit was squandered on businesses and projects that were low-value and often non-tradeable, merely serving to raise inflation and sustain the competitive trade imbalances that drove the credit flows in the first place. This is the reason why Italy today has so much bad debt. It’s a combination of the design of the euro area and problems within Italy’s political economy.

Deeper levels of scrutiny that are typical within systems with more capital depth were absent, making southern European states more exposed to financial risk than other countries that had high trade deficits, such as the UK and USA. It was these self-fulfilling fears of insolvency that originated mainly in the poor state of private credit markets, and the tight link between the health of national banking systems and public sector liabilities, that led to the sovereign debt crises of the 2010s.

Necessary reform

It now appears that officials in the ECB realise that the Italian banking system needs to be reformed, not just to isolate the mountain of bad debt and to prevent another financial crisis, but also for long-term reasons. There needs to be more accountability and transparency too.

Part of that involves bank consolidation. Consolidation has worked for Spain, which has reduced the number of its savings banks (cajas) from seventy to 12 since the financial crisis, with the Spanish economy growing strongly on the back of investment and exports. Consolidation with regulation that ensures that no bank becomes too big to fail is needed to improve the Italian and wider European banking system.

With the euro-area enjoying a sustained economic recovery, the last thing its leaders want is fears of another banking or political crisis to weigh it down. The price to pay in the short-term might be a hit to the Italian economy, but this perhaps is a price worth paying, both for Italy and the wider euro area.

In the UK, the crisis in the cost of living is back, as inflation, coming in at 2.9% in the year to August, has again risen above wage growth. The Bank of England says a major factor is the fall in the value of the pound since the EU referendum result, which has increased the costs of imports – in particular energy. Wage growth, up 2.1% in the year, hasn’t kept up. Adjusted for inflation, real incomes fell by 0.4% in the three months to July 2017.

Meanwhile, unemployment at 4.3% is now at a 42-year low, continuing to confound observers about the strength of the UK recovery as wage growth remains weak.

It may not feel like it but it is now over ten years since the financial crisis began, and we are nine years into a bull-run in equity markets in most major markets. Formally, the economy is said to have recovered. Unemployment is below its long-term trend of around 5%. Growth has been positive for many years, despite severe headwinds from years of fiscal consolidation. Inflation is rising.

Yet there is one highly abnormal feature of the British economy that could explain the weak growth in real wages. For the best part of a decade, the productivity gains that have driven rising living standards in the UK since the start of the industrial revolution have stalled, at least according to official data. Much of the increase in GDP since the crisis has come from ‘labour input’ – more people in work (often supported by high levels of net migration), people working longer hours, and more people returning to the workforce.

Low growth in labour productivity has meant that ordinary people in the UK have felt next to no benefit from the recovery of the economy in the form of rising wages. The return of high inflation threatens to put any gains they did see into reverse.

But is this the full story? Our research suggests that the productivity slowdown seen in the UK has been seen to varying degrees in all other G7 countries, but the performance of the UK should be an additional cause for concern. The UK has done particularly poorly due to unique frictions within its economy that have emerged post-crisis.

Figure 1 shows how the evolution of labour productivity, measured in terms of output per head, was faster in the UK between 1970 and 2008 than in other G7 countries. Starting from a lower level in 1970, productivity in the UK grew on average by 2.3% per year and by 2.0% in the other countries (weighted by share of total GDP), which included technological leaders such as the United States and Germany.

However in 2008, productivity decoupled from its trend in all advanced economies, with the biggest deviations in the UK. One would expect this at the beginning of any recession as weak demand creates ‘spare capacity’ in labour and capital. But this phenomenon should not last. In all other recessions since 1970, productivity soon returned to trend.

The impact can be seen in Figures 2 and 3, where we see the deviation of output per hour from the level implied by trend for the UK compared to the world’s technological leader, the United States, and then compared to all other G7 countries.

The UK and other G7 countries continue to deviate from their trend rates but to vastly different degrees. The US has also experienced low productivity growth in the last 5 years causing it so far only to revert back to its long-run trend level after a decade of rapid growth. But if the US continues to underperform on official measures, as seems likely, it too will slip below its pre-2008 trend in the coming years. The UK, however, appears to have done especially badly. Productivity (and therefore real wages) in the UK is 20% below where it should be based on recent trends, compared to just 10% below-trend for rest of the G7. More on the UK’s problems later.

The productivity slowdown across the G7 suggests one or more of four things has happened. Either demand remains too low in all industrial economies; the pre-crisis trend rate has fallen across the G7 due to structural changes in the economy; the pressure to deleverage in the wake of the crisis has reduced the willingness for firms to invest in products and processes that increase productivity; or productivity gains have not been picked up by the statisticians.

The demand explanation cannot account for a decade-long trend, and apart from a short policy-induced scare in 2015-16 in the Eurozone, deflation has not been a major issue in most of G7. It is possible, however, that delivering more robust and sensibly designed fiscal action sooner would have sped up the recovery ameliorated some of the productivity problems we now face.

While we are sceptical that the long-term trend that has driven growth in the United States and its trading partners for up to 150 years should be revised fully downwards to meet the most recent trends, we think a moderate deterioration in trend growth is a possibility. Mainly this is due to a decline in secular returns from a range of general purpose technologies – such as electric power and mass production – and the growth in the share of the low-productivity services sector in all G7 economies. The financial crisis may have simply exposed these underlying changes.

It is also plausible that as a result of the financial crisis and the experience of deleveraging, firms have increased their risk aversion and are reluctant to invest in the emerging general purpose technologies in nanotechnology and biotechnology, which promise a step change in industrial activity. This would also suggest a reduction in the trend-rate of growth, at least in the short term, across the whole of the G7, meaning lower growth can be consistent with full employment.

The fourth reason – that productivity gains have been hidden – we believe explains a significant proportion of the shortfall in all G7 countries including the UK. The emergence and growth of the Information Technology sector have hidden real productivity gains that have been realised since 2008.

A smartphone today, for example, has taken the place of a number of other devices such as cameras, GPS, audio players and games machines; and to a more limited extent they have substituted for personal computers altogether. Despite this, the cost of smartphones has fallen. Product consolidation in consumable electronics and IT sectors means that the formal measure of GDP understates the true level of output, adjusted for quality, and goes some way in explaining why productivity is low relative to the level of employment.  Further, GDP statistics do not account for non-monetary transactions, such as content produced on social media or the services provided by free app technologies that underpin the ‘sharing economy’.

But for the UK economy, further underlying aspects can be highlighted, as pointed out in 2014 in a paper from Bank of England’s Monetary Analysis Directorate. They suggest that low interest rates have increased  forbearance from banks on the debts of firms that in normal conditions would have been allowed to fail. Moreover, credit frictions have prevented funds from being matched with new profitable opportunities, and a sustained fall in real wages relative to the price of capital has encouraged firms to delay investment by expanding employment.

So while a global phenomenon of depressed productivity growth exists, the problem seems particularly acute for the UK. Our research suggests that the UK has suffered a decade of lost productivity growth but that it is closer to full capacity than implied by its pre-crisis trend. This means that the country may face a period of stagflation – weak growth and high inflation – that will create a dilemma for a Bank of England that is committed to keeping inflation at 2%. As inflation rises, real interest rates fall and sterling continues to weaken, the UK economy could begin to overheat. At which point, the Bank will be encouraged to raise base rates. But this could reverse efforts to raise productivity and if markets have little tolerance for higher interest rates could create more adverse macro effects.

This is the near-term outlook, However if, as the technologists suggest, we really are on the cusp of a new industrial revolution, which promises to offer quantum leaps in productivity and living standards, the long-run prognosis for the UK and indeed the rest of the G7 need not be so bleak.

The Taylor Rule, established by economist John Taylor in 1992, tries to target a level for short term interest rates that will stabilise the economy whilst maintaining long term growth based on three factors:

Actual inflation levels

Full employment vs. actual level of employment

Short term interest rates consistent with full employment

This means the rule will recommend raising rates when inflation is high or employment exceeds the perceived level of full employment and vice versa. Like all economic models, it is only as good as the data input, in this case assumptions about the long run neutral rate and the cyclical position of inflation. Historically, however, the Taylor rule has proved a useful guide to the appropriateness of monetary policy.

The change in central bank rhetoric would indicate that we have reached an inflection point where historically accommodative monetary policy will start to be reversed through the tapering of quantitative easing measures then the raising of interest rates.

                                                                                                                                                                     Baseline Taylor Rule Estimate for United States

                                                                                                                                                               Source: Bloomberg

At the peak of the financial crisis in mid-2009 the Taylor rule suggested that US interest rates should target a rate of -2%, but the Federal Reserve unsure of the effects of negative interest rates instead embarked upon a quantitative easing project designed to reduce the overall cost of credit by employing its own balance sheet. By 2013 the rule was advocating rates be raised to approx. +1% encouraging Chairman Bernanke to embark upon the first tapering of QE that caused the summer tantrum in the US Treasury market.

Today the Taylor rule suggests that rates should be nearer 3.75% in the US which is probably the largest disconnect between the theoretical normalisation of rates and actual interest rate policy sparking debate about where the peak in this hiking cycle will ultimately prove to be. For many the current neutral rate is believed to be around 2%, much lower than the historical average of nearer 4%, but probably explains the Fed’s new commitment to tighter policy despite the absence of wage inflation in the system. In any event it seems clear that fundamental models such as the Taylor Rule are pointing towards higher rates and the phasing out of QE.

The Fed is expected to announce balance sheet reductions in September leading to another hike in rates in December; The ECB to move to a reduction in QE during Q4 17, the Bank of Japan’s balance sheet growth is reducing; and the BOE surprised many with its more hawkish rhetoric of late leading the Gilt market to adjust its rate hike expectations in the UK. The causes of the higher levels of inflation in the UK are creating a greater divergence between actual and theoretical rates which may explain the difference of opinion in the future path of interest rates.

From the bond markets perspective the adjustment to higher rates will generate capital losses as yields move higher and if handled badly by policy makers negative sentiment could spread to other areas of the economy. Expect central banks to offer high levels of forward guidance and move forward very cautiously as they remove support from the financial markets.

Just as the dust started to settle with political stability somewhat mitigated and investors focus now on corporate earnings as a means of justifying high global valuations, Italy comes to the forefront. European markets have performed strongly and valuations are becoming stretched so that even the smallest shock would likely see equity markets weaken the question is to what extent? Italy, known for its political instability, high debt and resulting drag on the European Union is in desperate need of effective leadership and structural change. The political parties of Italy recently announced that they are in the process of coming to an agreement on new electoral law that, if successful, will almost certainly lead to early elections this September. The announcement on May 16^th saw markets deteriorate slightly, primarily in Italy where the FTSE MIB fell 2.31% followed by two falls of 2% on May 26^th and 29^th as the news unfolded. The most significant decline was in Italian Mid Caps which fell 2.51% led by financials. However, the relatively sober response suggests investors believe there is a low chance of a populist party being elected and subsequently an Italexit.

The Italian and German bonds spreads widened as the yield on an Italian 10yr government bond hit 2.18% (a 6.77% increase). The change in spread represents an increase of 188 basis points. Citigroup predicts spreads to widen further to as much as 300 basis points, levels that haven’t been seen since 2013.

 

German Bund / Italian BTP 10 year Yield Spread

                Source: Bloomberg

 

With the recent win of Emmanuel Macron as French President and the likely triumph of Chancellor Angela Merkel the Euro currency has been the stronger major currency, a further reflection perhaps that most investors currently place a very low probability of a populist triumph.

Should Italy’s political parties come to accept an electoral reform it is likely to take a shape similar to that of the German model; proportional representation with a 5% threshold. Considering this, and looking closely at the most recent election polls, only four of the political parties make the 5% threshold. The PD and 5SM stand at 30% each, Forza Italia and Northern League in the low teens and no party is on course to win a majority so a coalition is almost certain. Currently, consensus seems to suggest a coalition between PD and Forza Italia (both pro-EU parties) however 5SM and Northern League should not be ignored. Both are anti EU and would call a referendum. Should this coalition become likely, we would expect to see a big sell off in markets.

In conclusion, there are a few immediate obstacles to observe. The state of the Italian economy is the first and will most definitely play a part in influencing the outcome of the election. Support for the 5SM seems to rally whenever news of Italy’s economic performance turns for the worst. Initial economic reports this year have been promising with strong results coming from boosted inventories and consumer spending. If this continues, Italians may rally behind the PD. Secondly, poll predictions will likely influence markets and be a good indicator as to the possible outcome of the elections. Looking back at the Italian referendum, polls were fairly accurate in forecasting the vote and so investors will expect this to follow through in the elections. Finally, keeping a close eye on the interaction amongst parties. If the 5SM and Northern League form a coalition, it is very likely they could win the election. The result will see devastating effects to the markets. We remain cautious in the short term upgrading risk to ‘medium’.

With Emmanuel Macron’s comfortable, yet predictable win over Maine Le Pen, we look back at its effect on markets and potential opportunities on the horizon.

Initial Rally – April

Following the election of Emmanuel Macron as President this Sunday, market reactions have varied. Macron’s first round domination coupled with encouraging opinion polls magnifying the likelihood of a Macron presidential triumph meant markets had already priced in this best-case scenario prior to the weekend’s vote meaning French and European equities rallied, the Euro appreciated and French bond spreads tightened. Putting this in perspective, the movement over the four day period (21^st – 25^th April) saw the CAC 40 up 4.5%, MSCI Europe up 2.5% and the Euro/USD Spot appreciate 2.4%.

USDEUR Spot

Source: Bloomberg (Euro/USD)

Revaluation – Monday May 8

Following the election and given what markets had already priced in, there was little room for further gain. The CAC40 saw an initial sell off of 106 basis points raising concerns of a “buy the rumour, sell the fact” reaction, which was later offset by a partial recovery in the index of 65 basis points. The Euro has seen the greatest volatility as investors looked beyond the French Election. The Euro/USD Spot has depreciated as investors await the latest US CPI figures to be released on Friday providing a further indication of the likelihood of the FED increasing interest rates. The Euro also depreciated against commodity currencies as investors hedged their exposure to recovering prices.

Short-Term

Macron’s victory has provided some breathing room for those concerned about the rise of populism in Europe and is likely to give a further boost to risk sentiment in the short-term.

Whilst focus has shifted away from France, emphasis on the upcoming legislative elections should not be overlooked. The outcome is paramount to the ability of Mr Macron to govern the country and, at present, there is much uncertainty. Extrapolating results from the first round of the presidential election would suggest that the probability of a hung parliament is high. However, an OpinionWay poll for Les Echos on May 3 estimated En Marche! could win between 249 -286 seats, just short of an absolute majority of 289 seats. With this uncertainty and the pullback in equities on Monday it is likely that, should evidence appear that Macron could gain a majority parliament, French equities may see a further appreciation in value. With regards to the Euro and bond spreads, we see the Euro appreciating modestly over the year and bond spreads remaining fairly stable.

Long-Term

The next five years are very important for France. Should Macron fail to implement his policies it will only be a matter of time before France will be dealing with a more mainstream Front National and anti-establishment forces. This would have a devastating effect on France and see the likelihood of ‘Frexit’ increase.

Alternatively, if Macron follows through with the promises from his presidential campaign, France will provide some good investment opportunities over the coming years.

 

Market commentary tends to revolve around a limited set of topics. We have put together a list of nine frequently asked questions and our answers.

How is the global economy? In pretty good shape. Spring has sprung, according to IMF chief Christine Lagarde, and all regions are growing. The IMF reckons the global economy will grow by 3.5% this year after 3.1% last year.

Much of this pick-up is likely due to stimulus by the Chinese government and the ECB some while ago. However, growth has slowed quite sharply in the US and the UK recently and there are signs that Chinese growth might slow later this year.

And the next recession? No sign of an imminent downturn, in our opinion. But, surprisingly, the IMF thinks there is a 44% chance of recession in Japan over the next four quarters and 30% in the Euro Area and 22% in the US. Even though we do not expect a recession this year or next, there are reasons to be cautious.

Or the next inflation surge? Also unlikely. The feature of this upswing has been slower than normal growth and hence fewer inflation pressures. Even in the US and the UK, which have enjoyed the fastest growth in the G7 and have the least spare capacity, we cannot get unduly worried.

When and by how much will the Fed raise rates? If you believe the FOMC “dots plot”, then there will be two more 25 bps hikes this year and three next year. However, analysis by Absolute Strategy Research suggests the pace could be slower than that. The Fed funds future also implies a slower path of rate increases. We foresee no change in policy on 11th May but a strong chance of a 25 bps raise in June. Beyond that, take each meeting as it comes.

Are central bank balance sheets too big? Yes, this will be a big issue over the next two to three years. Certainly, Janet Yellen and Mario Draghi will face questions at every press conference in the near term until the Fed and the ECB decide on firm policies. Expect a  gently, gently approach to a tricky topic.

Should I worry about upcoming European elections? Not this year but maybe next year. Even if the polls are wildly wrong, Theresa May should win a large majority in the UK and Angela Merkel retain the German Chancellorship. Even if she doesn’t, Martin Schulz is the former head of the European Parliament and so more europhile than europhobe.

How will Brexit turn out? We shall never know because we cannot run an experiment in a parallel universe where the UK voted Remain. However, it is fair to say that UK growth may slow a bit over the next couple of years while the benefits will be political and tough to quantify.

What are the big risks? Each month we update our risk register, a judgmental record of the likelihood and potential impact of the key portfolio risks. In the latest version, there are nine with a high potential impact. But four of them – for example, a Theresa May defeat – are low or very low probability. In the near term, we worry about upsets in upcoming German and Italian elections and an ECB taper tantrum. Farther ahead, an EU break-up, global recession and a US-led financial crisis are key concerns.

And where should I put my money? In a typical sterling portfolio, we suggest being slightly under-weight equities and alternatives. We think portfolios will make money over the next six to twelve months. However, investment returns may be lower than normal and there is a fair chance of a setback at some stage. We prefer European and emerging equities to markets elsewhere.