Author: admin@hottinger.co.uk

Europe’s Success Story. Central bankers do not often make big, bold statements but Mario Draghi made one last week. He said, loud and clear, “our monetary policy has been successful” and listed six measures of Europe’s success story. Here they are, roughly verbatim …

• Since 2015 real GDP growth has been steady at between 0.3% and 0.6% qoq.
• The EC economic sentiment index in February was the highest since 2011.
• The purchasing managers composite index was the highest since April 2011.
• The unemployment rate in January was the lowest since May 2009
• In the last three years, the economy has created more than four million jobs
• The dispersion of growth rates (i.e. how closely countries are growing together) reached an all-time low since 1997.

We have checked his facts and he is right. To pick one, this chart shows the European Commission’s economic sentiment index against eurozone real GDP growth. It is a reasonable coincident indicator and it suggests growth is getting stronger. Indeed, the latest reading is 108.0 but previous peaks were higher – 108.3 in 2011, 113.1 in 2007 and 117.4 in 2000.

In other words, there is room for the eurozone economy to expand strongly for some while. We imagine that this is one reason why the ECB governing council left a bias to ease in its forward guidance. The ECB expects key official interest rates “to remain at present or lower levels for an extended period” (our underlining). There is little risk in the economy running hot for a while.

Market Puzzle. But the economic success story has not translated well into financial returns. True, bond investors have done well. The return on euro investment grade bonds (on the Bloomberg Barclays aggregate index) was 27% over the past five years. The comparable return in US bonds was 12%. However, Fed and ECB actions explain most of Europe’s higher returns.

In contrast, Europe’s equity market has lagged. Eurozone equity investors earned much better returns in the US than Europe. The FTSEurofirst 300 gave a total return of 61% over the past five years; the S&P 500 returned 92% in US dollars and 142% in euros.

Let’s look at those five-year returns in terms of valuations and earnings. The forward price/earnings ratio rose from 13.4x to 18.3x in the US and from 11.2x to 15.1x in Europe. So both markets gained from rising valuations.

However, forward earnings per share estimates grew in the US (by around 24%) but fell slightly in Europe. A similar pattern was evident in trailing earnings. The cause of European equities’ under-performance was in earnings rather than valuations.

There are grounds for optimism, though. FTSEurofirst 300 earnings are recovering from their mid-2016 low and prolonged low interest rates and economic growth should help that recovery, at least for non-financial firms. With middling equity valuations and rising earnings, we look for Mr Draghi’s European success story to spread beyond real GDP.

Philip Hammond’s first and possibly last Spring Budget was a low-key affair. It was also a triumph of competence over charisma, putting the era of George Osborne firmly in the past.

The Chancellor is a fiscal conservative but also a political realist. It showed. He left the deficit reduction path broadly unchanged but did enough on business rates and social care to fend off a revolt.

Economic Backdrop. The Office for Budget Responsibility (OBR) thinks growth will stay around 2% for now but weaken in 2018 and 2019. The official verdict is “cumulative growth over the forecast as a whole [will be] slightly weaker than in November”.

There are many moving parts in an economic forecast but the stand-out feature was slower consumer spending ahead. In the OBR’s forecast, consumption growth slows from 3% last year to 1% next year. Yes, household spending was strong after the EU referendum but only due to rising borrowing and falling savings. The OBR thinks higher inflation, slower borrowing growth and a stable savings ratio will undermine retail spending.

However, there was greater optimism on prospects for net exports and business investment. The former makes sense, thanks to the pound’s more competitive value. The latter is less obvious. The OBR says capital spending growth will pick up from zero in 2017 to nearly 4% in 2018. It does not explain clearly why.

Finally, the OBR has been consistently too optimistic about medium-term growth in recent years. Two years ago, the OBR expected UK growth to be 2.3% in each of 2016, 2017 and 2018: its latest numbers are 1.8%, 2.0% and 1.6%. Slower growth is bad for the public finances and the storm clouds are gathering.

Public Finances. The main story is a windfall in 2016-17 but pay-back in 2017-18, largely reflecting one-off factors and timing effects. Philip Hammond has “looked through” the ups and downs of 2016-17 and 2017-18 to end up with deficits of around £20bn in 2019-20 and beyond. This is a similar end-point to that in the Autumn Statement.

The Treasury reckons the Budget provides a give-away of £1.7bn in 2017-18. The OBR thinks the give-away is larger at £3.0bn. Either way, there was just a little less austerity for the year ahead.

However, another key story is the impact of the budget on the economy. This is best seen in the change in cyclically adjusted budget balance. There is little change between 2016-17 (0.8% of GDP) and 2017-18 (0.9%) which means fiscal policy is neutral. However, in 2018-19 and 2019-20 there are underlying budget cuts worth around 1% of GDP. In other words, fiscal policy will be excruciatingly tight from April 2018 onwards.

This has implications for monetary policy which will need to remain extremely loose. Alternatively, Philip Hammond will be forced to abandon his plans. Like any politician, he is putting off the day of reckoning.

Market Implications. The market reaction was almost zero … a few points up on FTSE 100 and a few basis points higher on the 10yr gilt yield. This budget has few big implications one way or the other for UK markets over the next three to six months. However, farther ahead, the implication is official interest rates lower for longer and probably some sterling weakness.

Economists are used to getting egg on their faces. Since we argued nearly two weeks ago that the next Fed rate hike would be in June, the Fed (notably FOMC chair Janet Yellen and NY Fed president Bill Dudley) has signalled that it expects to raise rates on 15th March. The only stumbling block is the February employment report due this Friday. According to Bloomberg, the market reckons a March rate hike is a 98% probability.

Why the sudden shift in FOMC policy after three years of dovish noise and behaviour? We can think of three possible reasons.

First, business confidence has soared since 8th November – the chart shows three mainstream business indices. This is not surprising in view of the Trump agenda of corporate tax cuts, deregulation and infrastructure spending. However, it is debatable how much of this agenda will make it into reality. Moreover, strong business confidence is not the same as a strong economy. Barclays and the Atlanta Fed both reckon first quarter growth is running at a moderate 1.8% pace, using “now-cast” calculations.

Second, the US stock market is hitting new highs. The Fed often treats stock indices as a “wisdom of crowds” indicator of the looseness or tightness of monetary conditions. The Dow, S&P and Nasdaq have all recorded new all-time highs over the past week, suggesting an easing of monetary settings. The Fed has decided to lean against this easing.

Third, there will be a change of personnel on the committee. There will be three new people – Trump nominees – on the FOMC this year and Janet Yellen is very likely to be replaced early next year. While Donald Trump is unpredictable and has railed against low interest rates in the past, he is unlikely to welcome steep interest rate increases. Perhaps the current set of policymakers decided to tighten policy while they can.

It is arguable whether this sudden shift in monetary policy towards early rate hikes is sensible but it looks as though the decision has been made. Looking ahead, two more increases, possibly three, look likely.

The most powerful person in the western world spoke last week. No, not Donald Trump but Janet Yellen. The head of the US central bank testified before two Congressional committees, setting the scene for US interest rate rises in 2017. So what did we learn?

What She Said. Ms Yellen’s formal remarks were brief by past standards and stuck faithfully to the script of the 1st February FOMC statement. However, a couple of phrases did catch the eye.

The first was “waiting too long to remove accommodation would be unwise”. This was quite hawkish by Janet Yellen’s normally dovish standards and the headline writers wrote it up that way. However, in central bank land, “waiting too long” can mean months and quarters. This is simply consistent with the Fed’s declared belief that there will be three rate hikes this year.

And the second was “changes in fiscal policy or other economic policies could potentially affect the economic outlook”. This is a candid reference to the new Trump administration’s likely policies. These include tax cuts (including corporate tax reform) and extra government spending as well as protectionist trade measures. All of these are reasons why the Fed might raise rates faster but none are guaranteed to occur. The FOMC will wait and see.

What The Fed Will Do. The starting point is the Fed’s projections last December. The FOMC’s collective wisdom was that by the fourth quarter of 2017 the unemployment rate would be 4.5%, headline inflation 1.9%, core inflation 1.8% and the Fed funds target range 1.25%-1.5%. In other words, lower unemployment, higher inflation and three rate hikes.

The Federal Reserve is close to hitting its dual mandate of maximum employment and price stability but is not quite there. In particular, the under-employment rate was 9.4% versus its low of 8% in the previous cycle. Thus, the Fed may try to squeeze some more slack out of the labour market before raising rates in earnest.

So, the crucial question is not whether the Fed will raise rates but when and by how much. The futures markets currently assign rate hike probabilities of 34% in March, 60% in May and 75% in June.

That may be overstating things, having been spooked by the words “fairly soon” in the latest FOMC minutes. We would not rule out a March or May rate increase but think it is more likely in June when there will be fresh forecasts and a press conference.

Significantly, Ms Yellen did not flag a March rate rise last week. Investors should mark her every word on 15th March for signals of a May increase.

Investment Conclusion. Our base case is 25bp interest rate rises in June and December and a fair chance of another in September. If this proves correct, then expect moderately higher Treasury yields and maybe a slightly flatter curve. A tighter Fed policy may unsettle US equities … but not fatally.

A month before the Dutch vote, should the markets be more worried about Europe’s political risks? True, five year CDS spreads, the classic worry-ometer, have widened a little but they remain well below 2011-12 levels. So let’s play devil’s advocate.

Conventional Wisdom. Harvard economist JK Galbraith coined the phrase “conventional wisdom” 60 years ago to describe commonplace beliefs which are acceptable and comfortable. Here is today’s conventional wisdom in six easy stages:

• The three key threats are Geert Wilders in the Netherlands, Marine Le Pen in France and Alternative fur Deutschland in Germany
• Geert Wilders will win the most votes but will not win power. The likely outcome is a five or six party coalition led by the current prime minister, Mark Rutte.
• Marine Le Pen will win the first round of presidential voting but lose the crucial, second round no matter who she faces.
• AfD is only polling around 12% of the vote compared with 30% for Martin Schulz’s SPD and 33% for Angela Merkel’s CDU and has little chance of doing much better
• In practice, a bigger problem for European markets is the ECB and its QE programme
• And, finally, there were big political shocks last year, namely Brexit and Trump, but the markets rode them without trouble

Unconventional Wisdom. Let’s see if we can dent that narrative. We agree that Wilders will not be the next Dutch PM. Moreover, Merkel and Schulz are strong favourites and will see off Frauke Petry. Thus, we should focus upon Marine Le Pen.

Le Pen, 48, is at the height of her political powers whereas Francois Fillon is fighting a corruption scandal and Emmanuel Macron, 39, is relatively inexperienced. In fact, she called Macron “my ideal opponent”: he is affluent, young, liberal and cosmopolitan.

She has abandoned some of Front National’s more extreme policies such as the death penalty and focuses upon globalisation, the ruling elite and the EU. What is the French for “take back control”?

Like Trump, she is a charismatic candidate facing some bland opponents. She is a good television performer; she appeals to the younger generation; and she is a campaigner with a cause. No one thought Donald Trump would win; no one thinks Marine Le Pen will. And if Le Pen does win, she has promised an EU referendum within six months.

However, she faces two big obstacles. First, high disapproval ratings among non-Front National supporters – a case of Anyone But Marine for many people. Second, the EU gets high approval ratings among French voters, by 60% against 28%, which makes her anti-EU message a tough sell.

Investment Conclusion. The French election is a binary event – a Macron win would be good for French assets; a Le Pen win would be bad. Thus, assigning probabilities to outcomes is not that helpful. Perhaps the best long only strategy is to ride the rally for now but to head for the exit if Marine Le Pen’s second round polls versus Macron move decisively above 40%.

Just when Ireland thought its troubles were easing, along came the UK vote to leave the EU. At first sight, this is bad news. Indeed, John Bruton, a former Irish prime minister, thinks that Brexit might deal Ireland’s economy an even heavier blow than Britain’s. We are not so sure.

Conventional Wisdom. The orthodoxy is that Brexit will damage the UK economy via three channels – uncertainty, trade and foreign direct investment (FDI). Uncertainty will hurt the UK economy near term as firms and households postpone big ticket spending. Farther ahead, the UK will battle strong headwinds from being outside a free trade bloc more than five times its size. And it will be less attractive for FDI for the same reason. Our rough guess is that UK long-run growth may be say 0.25% a year lower as a result.

Since Ireland is one-eighth the size of the UK in GDP terms and has a population of 4.7m versus the UK’s 66.0m, one can see why Mr Bruton is gloomy. One credible estimate says that Ireland’s exports to the UK could fall 30% in the decade after a hard Brexit and the Irish economy could be 4% smaller than if the UK had remained within the EU.

Unconventional Wisdom. So far, so bad. But there are some positive arguments to be made.

One, the Irish economy is in a good place. Real GDP has grown strongly since 2012 and could expand by around 3% this year; the jobless rate has more than halved over the past five years; inflation is roughly zero; and the current account is in a huge surplus. The old-fashioned “misery” index – the unemployment rate plus the inflation rate – is at a nine and a half year low.

Two, the Irish economy is now less exposed to the UK economy. For example, the proportion of Ireland’s exports going to the UK has fallen from 50% in the 1970s to just 15% now. Ireland exports nearly as much to Belgium as to the UK!

Three, there will be two years of negotiation after the UK triggers Article 50. This gives Irish businesses a breathing space to plan and take evasive action.

Four, Brexit is an opportunity as well as a threat. Already, there is talk of banks, fund managers and manufacturers moving part or all of their operations to Dublin or elsewhere. Access to the EU single market is a big plus point, especially when involving complex supply chains.

Ifs and Buts. Sadly, life is never problem-free. Ireland also needs to worry about fall-out from the Trump presidency and elections in Europe this year; the banking system remains convalescent; and Brexit raises profound questions over relations with Northern Ireland. In addition, sterling’s 10% fall against the euro since the UK vote has hit Irish exporters, especially in the agri-food sector.

Moreover, Ireland does not have much control over its own destiny. It does not set its own interest rates or control its own currency; it is only one of 27 EU voices in the Brexit negotiations; and it is at the mercy of arbitrary decisions made in say London or Washington.

Conclusions. Even so, we reckon that the pros and cons of Ireland’s outlook are finely balanced. In fact, the resilience of the Irish economy and financial system over the past decade make us optimistic.

And it appears the markets broadly agree. The Irish Stock Exchange Index has rallied by over 20% since its 24th June low and is just 3% below its recent high. Meanwhile, the 10yr Irish gilt spread over bunds is just 70 bps, not far from its average over the past year. The outlook may be uncertain but the financial markets have a positive tone.

Before the EU referendum, the Treasury, the Bank of England and the IMF warned that the economy could fall into an immediate recession if the vote was No. This morning, the Office for National Statistics said that the UK economy grew in the fourth quarter, by 0.6% qoq for the third quarter running.

Annual growth was 2.0% in 2016 after 2.2% in 2015 and 3.1% in 2014. This confirmed that the UK was the fastest growing G7 economy in 2016. The figure is provisional but revisions are usually modest.

What Was Driving Growth? In a word, services. The service sector comprises 79% of the economy: growth of 0.8% qoq accounted for the entirety of fourth quarter UK growth. The ONS pointed in particular to a “strong contribution from consumer-focused industries”. Beyond services, manufacturing grew by 0.7% and construction by 0.1% but mining (which includes North Sea oil) tumbled by 6.9%.

Where Is Growth Going? With hindsight, the economics fraternity should have seen the robust growth in the second half of 2016 coming. It was not a case of a “crisis in economics”, as the Bank’s chief economist, Andy Haldane, suggests, but rather failing to see signs that were there.

The chart shows one unfashionable example. Few economists look at money supply figures nowadays but M1 has been a reasonable predictor of real GDP growth since the turn of the decade, with a two to four quarter lead. M1 growth has picked up from 5.3% yoy in late 2015 to 11% in late 2016 so it is no great surprise that real GDP growth has also accelerated. Another couple of oft-ignored indicators – the CBI trends survey and the OECD leading indicator – also heralded firm second half growth.

Even so, economic logic points to a slowdown ahead. Faster inflation due to the weaker pound will squeeze real incomes and slow consumer spending. Uncertainty about the UK’s future relations with the EU should deter capital spending by both domestic and foreign firms. In particular, there may be a move to consolidate supply chains within the EU. The budget deficit is still too high which will discourage government spending and so on.

However, the key question is how big a slowdown and how soon. Our guess – no more than that – is that there will be a distinct slowing but no recession. The first and shorter slowdown will be over the next six to twelve months, as weaker real incomes hit retail spending. The second and longer deceleration may come as Brexit talks proceed and likely turn nasty.

The other major question is how current buoyancy and future headwinds blend into the outlook. The first and maybe the second quarter of 2017 should print reasonable growth numbers. Thereafter, look for weaker data to emerge.

Market Implications. In the near term, firm economic numbers should support UK equities and the pound, while rising inflation will keep gilt yields under upward pressure. Farther ahead, say from the second quarter onwards, signs of modest economic weakness may reverse those trends.

On Tuesday, Theresa May set out her plan for Brexit in a 40-minute speech at Lancaster House. This is our take.

The Speech. It was well-written and set out with clarity how the UK government will approach Brexit. After months of “Brexit means Brexit”, a plan has emerged blinking into the daylight. In truth, much of it was feel-good guff but one point was abundantly clear – control over immigration and freedom from the European Court of Justice are paramount. Presumably the prime minister is seeking maximum political gain and hopes no one will notice the economic pain.

To summarise, she proposed four principles and twelve objectives. The four principles were certainty and clarity at every stage, a stronger Britain, a fairer Britain and a more global Britain. The twelve objectives were:

• Certainty wherever possible.
• Control of our own laws.
• Strengthening the United Kingdom.
• Maintaining the common travel area with Ireland.
• Control of immigration.
• Rights for EU nationals in Britain, and British nationals in the EU.
• Enhancing rights for workers.
• Free trade with European markets.
• New trade agreements with other countries.
• A leading role in science and innovation.
• Cooperation on crime, terrorism and foreign affairs.
• And a phased approach, delivering a smooth and orderly Brexit.

So far, so good. The speech was largely conciliatory towards the EU and was welcome news for the markets and businesses in filling a policy vacuum.

The Problems. However, the speech was also riddled with difficulties.

For example, there was a contradiction between rejecting “anything that leaves us half-in, half-out” and seeking a customs agreement which allows “current single market arrangements in certain areas”. In other words, we shall be out of the EU but we would like to buy BMWs on preferential terms and sell you financial services. That looks rather half in, half out to us.

In another instance, there was wishful thinking that “we will not be required to contribute huge sums to the EU budget”. EU officials currently think that Britain’s exit fee will be about €40bn to €60bn and any partial access to the customs union will of course require an annual payment.

And so on and so on.

Problems With Europe. Mrs May’s clarity had the disadvantage of shining a light on problems ahead. Echoing Boris Johnson’s have-cake-and-eat-it line, she assumes that the EU comes to the negotiating table full of generosity and goodwill. That seems highly unlikely. Michel Barnier, the chief EU negotiator, has made plain that it will be divorce first, trade deal second. It will be March 2019 before the UK can discuss buying BMWs.

And even when Britain gets to discuss trade, several European ministers have made clear that there will be no “cherry-picking”. You are either in or out. Both Norway and Switzerland have found that the EU negotiates tough deals.

Problems At Home. Ignoring the irony that Mrs May is keen to preserve one union while leaving another, she spent some time reassuring Scots, Welsh and Northern Irish listeners. Both the Scottish and Irish questions will be key sub-plots of the Brexit process.

And Mrs May promised a vote for both Houses of Parliament but made no mention of what happens if Parliament votes No. Three-quarters of MPs favoured Remain so it is hard to see much enthusiasm to vote Yes. Presumably the intention was to confirm that there will be parliamentary scrutiny. This is welcome but is unlikely to be an easy ride.

Market Implications. Despite a big sterling bounce and a 107-point FTSE fall on Tuesday, the markets were in reality quite calm. Near term, sterling may remain soft which should be good for the FTSE 100 but bad for gilts. However, at some point, the negotiations will turn acrimonious in which case equities may tumble and investors will flee to the safe haven of gilts. Overall, caution re sterling assets is warranted.