Greatness, local reflation and Europe

Transcription

1 Greatness, local reflation and Europe London February 24, 2017 The Great Again Club Brexit and Trump election in 2016 have been interpreted as outcomes born out of similar political and social dynamics. They also occurred in country-specific contexts. In the UK, people were keen to regain full sovereignty and control over immigration beyond what being a member of the EU allowed. The greatness the UK contemplates lies in the independence of its representative democracy, at the expense of the cost of leaving the EU, and at the risk of geopolitical irrelevance in a world dominated by large regional blocs. In the US, immigration also played a role, but sovereignty reflected the feeling that the country was not getting its fair share of existing external agreements and commitments. The greatness the US thrives for is a renewed economic dominance based on narrow and short-sighted national preference, at the expense of the existing framework that structures international relations. If Brexit brings uncertainty to the UK alone, Trump election brings uncertainty to the whole world on a wide range of issues relevant to global investors. Brexit is a subject for UK assets alone. Trump s presidency is central to most assets. The program of the new US administration is actually pretty clear: a fiscal expansion through tax cuts, less regulation, infrastructures projects, a tax reform that brings the US tax system closer to that of its peers and the renegotiation of trade deals on a case-by-case basis. The White House and the Republican House are aligned on most of these issues, so one should expect them to come out eventually. At face value, the program of the new US administration is positive for US growth and inflation. It calls for a quicker normalisation of the Fed, a bubbly dollar, and a rotation from bonds into equities. The market has embraced these themes with passion in the immediate aftermath of Trump victory. Since the beginning of the year though, investors seem to have second thoughts about it. The uncertainty relative to the timing and the magnitude of these policy shifts has casted a chill over the early enthusiasm. Positions are being cleansed. Short-term players and secular doubters are leaving. The mechanisation of markets over the past few years, courtesy of regulation and risk management supremacy over return, has made any source of short term uncertainty almost unbearable. The year 2016 was a point in case. Events were treated ex ante by investors as life-threatening, but proved to be irrelevant ex post for any investor with a time horizon beyond a few weeks. Things have not changed in The uncertainty coming from Trump s program and personality has managed to make investors lose sight of the main story. Time has come to reassert where things stand. In a typical oil counter-shock dynamic, reflationary forces have followed the low in the oil price of a year ago. These positive forces have begun to surprise from the end of Q1 2016, at a time worries about an imminent US recession were running high. They have also proven to be unaffected by the Brexit vote. This under-appreciated reflation was in place well before the US election. Afraid of their own shadows, market participants and policy makers alike kept an extremely cautious stance up to this election, as if the world were on the verge of deflation. The surprising victory of Trump has unleashed the long-due repricing of reflation. However, the deflationary bias has not disappeared entirely. Some see reflation only conditional on a fiscal expansion in the US. These are keen to unwind their position today. This should prove a fantastic buying opportunity. The US economy is cruising through full-employment with strong momentum, with the likelihood of further impetus from tax cuts and a fiscal expansion for No doubts on growth and inflation can survive such a combination. 1

2 Local rather than global reflation Some confusion seems to reign in regards to the nature of the current reflation. The global rise in headline inflation as the product of oil price stabilisation in the USD range after the low of February 2016 is often referred to as global reflation. A more suitable label should be the exit from the transitory disinflation falsely interpreted as deflation in most of This misunderstanding is important for the future, as the market global reflation should end by March 2017 when base effects from the oil price are likely to peak. Further momentum in global inflation would only happen if commodity prices reengage in a steady upward trend. Although some upside in oil price is contemplated in the very short term, the dominant view is that supply is revived above USD 50, as we have seen with the sharp increase in rig counts in the US since mid This should prevent any material trend to develop, at least one that would fuel commodity-driven global inflation. On top of higher price-elasticity of oil supply, demand considerations should be added to the benign outlook of the oil price. China is expected to continue slowing down in 2017, especially through the construction sector, preventing long-standing upward support for commodity demand. Contrary to the traditional template of global recoveries where starting conditions are similar across countries and regions, and the acceleration of growth in developed countries opens the door to higher commodity prices due to the sustained revival in emerging countries as well, the business cycles of developed and emerging countries are completely out-of-sync today. China is in a lingering recession below 8% growth, while developed countries are barely entering the late phase of their own business cycle where growth and inflation accelerate. Such a configuration is similar to that of the late 90s when commodity prices did not really recover from the Asian crisis, while developed countries experienced strong growth. The lack of upside risk in commodity prices mentioned above does not even factor in Trump s potential shift in trade policy. Any push for globalisation is conducive of sustained pressure on commodity prices as delocalisation to more commodity-intensive countries is the name of the game. Any retrenchment away from globalisation works the other way round. If anything, it should exert downward pressures on commodity prices. Adding the specific of the US being a growing producer of energy and Trumps commitment to lift some regulatory constrains for the industry and one can even be concerned by downside risk on the oil price from current levels. All this leaves us with a limited risk of global reflation going forward. Inflation should come from markets where supply-demand is tight, namely non-commodity and nonglobalised markets. The crux of the analysis stems from measures of output-gap across countries. Both levels and dynamics are strikingly different between developed and emerging countries. The largest emerging countries have inherited slack from their recent deep recession (Russia, Brazil, and Argentina), their expected slowdown (Mexico) or their protracted downward trend (China). In sharp contrast, the US exhibits signs of labour market tightness, wage pressure and core inflationary upside risk, in the context of accelerating growth in Although slack still exists in Europe, the speed of growth relative to potential means that further resorption is due to continue in Note that tighter labour market regulation in Europe makes the dynamic of the labour market (decrease in unemployment) more important than the level of the output-gap (level of the unemployment relative to equilibrium) for the setting of domestic inflationary pressure. This is known by economists as the hysteresis effect. The genuine reflation story is neither global, nor commodity-driven. It is localised in developed countries, and originates from tight supply-demand in the least tradable goods and services of these economies. The US is spearheading its European and Japanese peers in that regard. This is why USD funding is still very much at risk of getting more expensive in the year ahead. It would be again a huge problem for USD price-takers such as emerging countries, but not so much for Europe and Japan which enjoy independent funding in their own currencies. The current enthusiasm for global reflation has supported commodity currencies and emerging assets, especially in the context of investors looking to avoid Europe before the French election of April- May. By March, the base effect from oil should wane, discrediting the global nature of reflation. At the same time, US core inflation dynamic should reinforce itself as the economy sails along 2017 with momentum. Initially a US-centric phenomenon, this local reflation should be enjoyed as well by Continental Europe and Japan, later in 2017 or in The misunderstanding between global and local reflation should be cleared as the European political risk recedes, most likely after the French elections of early May. Relative value strategies across regions (Europe, commodity producers, and emerging countries) should offer attractive information ratios to global portfolios in

3 Last chance of political drama in the EU: May 7 The rejection of the Italian referendum was the first reassuring piece of news for anyone concerned with the risk of anti-establishment parties reaching power and questioning Italy s EMU and EU membership. Furthermore, the Italian Constitutional Court has definitely ruled against the ballot system (two rounds) for the lower house, killing for good such risk at the next general election (likely in Q1 2018). Specifically, on current opinion polls, a single-round system raises the bar too high for anti-establishment parties to win a majority in the Lower House. More definitively though, whatever happens in the Lower House, the Senate is still under a fully proportional system, leaving traditional parties in the driving seat. Thanks to the rejection of the referendum, the Senate has kept its equal power with the Lower House for the government s nomination and the passing of legislation. This means that in the unlikely event antiestablishment parties were to dominate the Lower House, they would neither be able to form a government, nor be in the position to move forward any legislation threatening current EMU and EU commitments. Investors looking for institutional trouble in the EU would prove wrong to focus on Italy from now on. According to current polls, they should not expect much from the Netherlands and Germany either. Far-right, anti-immigration and anti-establishment parties could gather 20% and 11% of parliament at most, respectively. All other parties having ruled out entering into a coalition with these far-right parties, pro-eu governments in both countries are almost a given as of today. This leaves investors with the sole possibility of the far-right Front National (FN) win in the second round of the French presidential elections. The FN candidate, Marine Le Pen, is leading the polls for the first round, so is highly likely to reach the second round. Her likely contenders are still expected to win in the second round, but by a margin that does not completely rule out a FN win. Her high rejection rate should make an eventual win very difficult though. However, abstention could be high enough to deliver a tight race in the second round. Investors might thus have to wait until May 7 to get more clarity on political risk in Europe. Similarly to the Brexit referendum and the US election last year, the French presidential election has become a focal point for investors in If a pro-eu president comes out of the French elections, it would be an all-clear signal for risky European assets currently plagued with a large political risk premium. In the unlikely case Le Pen becomes president though, not much would happen as far as legislative activity is concerned. The ballot and non-proportional system for the election of French representatives that follows the presidential election in June would surely leave the FN far short of a majority. Polls suggest a maximum of 10% of FN representatives in parliament at the June election. As in the case of Italy, political stalemate is actually the worst-case scenario for France, not the exit from the EU or the EMU. Specifically, there will be no democratic and legal ability to question existing European commitments with a pro- European parliament in place. Most likely, France would pay the price of political uncertainty through tighter financial conditions, as Italy experienced from mid-2011 to 2013, acting as a sobering feedback loop for the population and politicians. Chaos in France under Le Pen would be highly likely in the very short-term, but the institutional changes called for by the FN and feared by some investors would not happen, leaving the risk of EU breakout extremely more remote than currently feared. Once in power, populist and anti-establishment parties are bound to loose support, because of the economic and social costs of their impractical policies, their eventual need to deal with the real world through orthodox policies, and thus their loosing of the desperate protest vote. Like in Greece and Spain before, a Le Pen victory would bring short-term pain to France and the EU, but for significant long-term gains. The 40% protest vote would have had a go, leaving the 60% reformist vote prevail over the medium-term out of a short-lived crisis. Investors should not get too much carried away by the doomsayers on Europe, and consider history and institutions as key elements in their analysis. In the most likely event of a pro-eu French president, the political risk in the EU would not only collapse. It would also open the door to a renewed pro-eu momentum from newly elected governments (Netherlands, France and Germany) for the following years. Member countries would be more likely to unite behind the EU and EMU banners to face ongoing international challenges. These include defence, immigration from outside the EU, terrorism, the Brexit, and relations with Russia and the new US administration. For investors, risk would shift suddenly from the disintegration of the EU to all other sort of concerns outside of the EU. In other words, the EU would turn into a more comprehensive block, a source 3

4 of geopolitical and economic stability, offering more visibility and hence safer assets for global investors. Keep an eye on 7 May, but do not ignore the huge upside offered by European assets in the most likely outcome. Finally, investors would probably welcome such possibility as they are currently accumulating positions, in part by default, along themes that are likely to be much challenged after the summer by a fiscal expansion in the US, a swifter pace of Fed normalisation, and China s extreme weakness on capital flight. In other words, 2017 should be divided in two halves, offering attractive relative value trades across themes and regions. This time again, a good deal of alpha generation should come from the reading of the mechanisation of markets, and the way it divides the year in sub-periods. Arbitraging others constraints, not overreacting to short-term drama while keeping an eye on the big picture, should bring good rewards to investors in Edited in London on 24 February 2017 This document is intended for professional clients. It cannot be used for any purpose other than that for which it was intended and cannot be reproduced, distributed or communicated in its entirety or in part to third parties without prior written permission from H20 Asset Management LLP. This document has been produced purely for informational purposes. It consists of a presentation conceived and created by H20 Asset Management LLP using sources that it regards as reliable. H20 Asset Management LLP will not be held liable for any decision 4

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