The Global Economic Doctor Brief
April 11, 2019
Dr. Scott B. MacDonald
Steering through 2019 – The Merits of Being Cautiously Optimistic
Financial markets have had a good run thus far in 2019. Indeed, the bull market in U.S. equities could well continue for some time to come. Bond markets also have enjoyed a strong boost through March and into April. In discussions with several asset managers, most are “cautiously optimistic”, though many see 2020 as a potentially more challenging year in the U.S. clouded by electoral politics and the tapering of stimulus.
For now, key drivers for the positive momentum in U.S. financial markets are: the U.S. economy appears set to run at a pace of above 2.0% through 2019; unemployment is at multi-year lows; the Federal Reserve is on hold (and likely to remain so); corporate profits continue to be strong; and there is an expectation of a U.S.-Chinese trade deal. It should be noted, however, that bond investors are perhaps a tad more wary about the future, in particular over slower economic growth which translates into low inflation and lower yields on bonds.
There is a sense of bullishness even in the bond world. Saudi Aramco’s new bond deal received over $100 billion in orders (vs the planned $10 billion), smashing records for an emerging market bond sale and even rivaling some of the biggest deals in advanced economy markets. Saudi Arabia is rated A1 (stable), A- (stable) and A+ (stable).
The quest for yield (and willingness to assume risk) has extended deep into the universe of emerging markets, including what some call frontier markets — sovereign issuers, such as Uzbekistan, Benin and Ghana. Many investors want the yield that comes with these higher risk sovereigns. As the Financial Times’ Nikou Asgari noted in March 2019 of Benin and Ghana’s attractiveness: “The two nations are heavily dependent on their agricultural sectors, and will be hoping to entice investors with juicy yields. A decade of low interest rates in the west has opened the global bond market to new emerging market borrowers as investors hunt for higher returns.”
While international capital markets are being tapped by various governments for needed economic objectives, there is perhaps a little too much shine on some of the lower-rated emerging market bonds, obscuring the highly risky nature of some of these credits. The concern is that some investors may find the yield attractive, but might miss the full risk of what they are buying.
Benin, for example, has an economy based on cotton and cashew exports. Rated B by Fitch and B+ by S&P, investors should remember that this is a small economy (at a little under $11 billion of GDP), which is heavily dependent on Nigeria, its largest trade partner. If nothing else, Nigeria is an erratic economic performer, itself heavily dependent on oil prices. Moreover, Benin shares borders with Niger, which is suffering from the blowback of tighter European controls over migration; some of that blowback could extend to Benin.
But there is more to international financial markets than Saudi Arabia and frontier markets like Benin. The state of the global economy remains of central importance. Although there are plenty of storm clouds on the horizon, the growth picture remains intact. The IMF’s April 2019 Economic Outlook report, with the title of “Growth Slowdown, Precarious Recovery”, notes that world output will slip from 2018’s 3.6% to 3.3% in 2019, before moving faster to 3.6% in 2020. Recession is not expected, though growth will slow (in the U.S. from 2.9% in 2018 to 2.3% in 2019 and 1.9% in 2020).
The IMF was cautionary, but not overly gloomy (going back to the outlook of asset managers who said they were cautiously optimistic). The Fund noted that global growth slowed sharply in the second half of 2018 from 3.8% to 3.2%, with industrial production and world trade hit hard. Growth rates would have dropped further without consumer sentiment holding up strongly.
The IMF’s chief economist Gita Gopinath noted that the second half of last year was “a delicate moment for the global economy.” She also stated, “While a global recession is not in the baseline projections, there are many downside risks.” Chief among these is a further downgrading of international trade, as the Trump administration is strongly suggesting that it will embark upon a new trade war with the European Union (EU) in the upcoming months. Italy is already in recession, the German economy is struggling to stay in the growth column and France’s economy is weak. A trade war with Europe, especially if it targets autos, could push the EU into recession. What is expected to keep the global economy out of recession in the 2019-2020 period is stronger growth from emerging market economies, such as Brazil, China and India.
Geopolitical risks also remain a factor, though they should not be overstated. We see the following as the main risks:
The challenge in 2019 is to gauge if those dark clouds on the horizon remain on the horizon or if they advance and cause market turmoil. We think that most of the dark clouds stay out there, leaving markets to make further gains. That said, some risks will outweigh others. Although we would not categorize it as a geopolitical risk, the heavy burdens of a number of sovereign borrowers (including the U.S., U.K., Italy, Japan and France) is something that will increasingly come into play through the year as governments consider their options to provide stimulus to stave off the eventual recession.
The Global Economic Doctor Brief
February 27, 2019
Dr. Scott B. MacDonald
Haiti – Under the radar, but not without importance
Although what goes on Haiti has little impact on global markets, the recent round of riots and demonstrations against President Jovenel Moïse fits into a larger picture of the Caribbean as a region under increasing stress. This comes from a number of directions, including the standoff in Venezuela between the dictatorial Maduro regime and its rival Congress-backed opposition government; the ongoing Venezuelan refugee crisis; Cuba’s economic downturn; and a more sharp-elbowed U.S.-China and Russia rivalry in the region. Haiti only adds to the list.
On February 14, 2019 the U.S. State Department issued a “do not travel” advisory for Haiti. In its press release, it was noted, “Protests, tire-burning and road blockages are frequent and unpredictable. Violent crimes, such as armed robbery, are common. Local police may lack the resources to respond effectively to serious criminal incidents, and emergency response, including ambulance services, is limited or non-existent.” The political upheaval is hurting the economy, as distribution of goods (mostly done with trucks) is breaking down and productivity is slumping.
Haiti is the poorest country in the Caribbean, facing massive problems with poverty, overcrowding, poor or non-existent infrastructure, illiteracy and severe environmental problems. Rule of law has been a challenge in many parts of the country. Since a massively destructive earthquake in 2010, Haiti has struggled to regain economic momentum. Despite efforts to rebuild Haiti in the aftermath of that natural disaster, the problems have kept coming —recurrent hurricane damage (2012 and 2016 were particularly brutal); a cholera outbreak (2013); drought (2015-2016); and a rise in inflation in 2018 and 2019. Economic growth has only recently returned. The latest round of societal turmoil is a result of public discontent with higher food prices and the Moise government’s failure to prosecute embezzlement from a multi-billion-dollar Venezuelan oil program, PetroCaribe.
PetroCaribe was created during the Chavez government in 2005 (when oil prices were much higher) to help a number of Caribbean and Latin American countries by providing oil at preferential terms. A January report from Haiti’s Superior Court of Auditors brought the linkage to Venezuela and corruption of Haitian officials into sharp focus. The report cited substantial mismanagement practices and the suspected diversion of nearly $2 billion from the PetroCaribe fund. According to Georges A. Fauriol, Senior Associate, Americas Program, at the Center for Strategic and International Studies, “The report highlights individuals from no fewer than three successive Haitian presidencies, and follows a parliamentary report issued more than a year ago that covered many of the same allegations – all left unanswered.”
What is most worrisome about Haiti is that there are calls for an unconstitutional removal of Moises from office. Haiti has gone this path in the past and the outcomes have not been positive for a return to political stability or economic development. It also raises the specter of greater political violence and more refugees. There have already been reports of Haitians fleeing to the Bahamas and Turks and Caicos, including the sinking of one boat which resulted in close to 30 deaths.
Moise was sworn in as president in 2017, pledging to fight corruption and bring investment and employment to Haiti. Moreover, his inauguration marked Haiti’s return to constitutional rule one year after ex-President Michel Martelly left office without an elected successor in the midst of opposition protests and a political stalemate, resulting in suspended elections.
Haiti’s instability is of interest for the U.S. The Trump administration is moving to cut off permission for thousands of Haitians to live in the U.S. under the Temporary Protected Status (TPS) program (a temporary entry into the U.S. granted to people from countries beset by war and catastrophe). In response to Haiti’s political meltdown, the U.S. has encouraged political dialogue, though most of the rioting and looting appears without central leadership, more bordering on chaos.
Haiti’s political upheaval is a point of concern for the Dominican Republic, with which it shares a relatively porous land border. The Dominican Republic is more prosperous than its smaller neighbor and there are concerns that if the chaos continues, some of the problems will spread across the border and disrupt trade between the two countries. There has even been talk in the Dominican Congress about the construction of a wall between the two countries.
On another diplomatic and economic front, Haiti’s current upheaval is likely to make one of the Caribbean country’s recent suiters, China, cautious. Over the last several years China has been more aggressive in peeling away those countries that still recognize Taiwan as an independent country (as the Republic of China). Beijing had success in 2018 in peeling away the Dominican Republic from Taiwan as it did with Panama in 2017. This led to considerable speculation over whether Haiti would soon follow suit. Thus far is has not.
China’s interest in Haiti have been carefully measured. According to International Monetary Fund, imports of goods from China to Haiti have expanded from $56 million in 2006 to around $503 million in 2017, pushing the Asian country into the ranks of one the Caribbean nation’s largest trade partners. China has also indicated an interest in the potential exploitation of Haiti’s gold, silver and copper resources. And, if conditions offered enough stability, the island-state could be an opportunity for Chinese construction companies (likely backed by Chinese bank loans). Indeed, a $4.7 billion renovation plan for the Haitian capital, Port-au-Prince, was floated in 2017 by China’s Southwest Municipal Engineering Design and Research Institute.
Haiti is in desperate need of assistance and investment. From China’s perspective, Haiti is not entirely without value – despite the current round of troubles. The Miami Herald’s Jacqueline Charles (May 25, 2018) noted, “Haiti’s proximity to the U.S., its duty-free access to the U.S. market for Haitian-sewn apparel and foreign relations ties to the U.S. also are attractive to China’s geopolitical interests.” Although Venezuela’s economic and political disasters have no doubt made China more cautious to any new Caribbean ventures, it would probably only take a small amount of investment in Haiti to make a difference.
For many Haitians, Moise now represents yet another round of corrupt governments. Public discontent is halting economic activity in the country and the linkage to Venezuela via PetroCaribe only makes matters murkier. Haiti did cut ties with Venezuela this month, but only after considerable pressure from Washington and after it was revealed that the Maduro regime had sought to bribe the Caribbean country by offering to reprogram some of the PetroCaribe funding.
With the government shut down and much of the economy at a standstill, protesters have vowed to keep up the pressure until Moise resigns. The question is, who or what would replace him? It is uncertain that any of the major opposition figures would be able to quickly restore order and jump-start the economy back to life.
Haiti may not be Venezuela, but the societal upheaval is putting the country back in the news for all the wrong reasons. It also sends a signal that the Caribbean is increasingly becoming a region where the U.S. must maintain a more active role.
The Global Economic Doctor Brief
February 19, 2019
Dr. Scott B. MacDonald
The Week Ahead
Summary: While it will be a slow week for economic data, the trade front is active. Considering the relatively positive momentum in global equity and credit markets, investors have built in positive outcomes for major trade issues – at least for now. But trade deals are notoriously difficult to conclude, as we are seeing with Brexit and Sino-American trade negotiations. Moreover, the Trump administration appears to be considering opening a new front in the trade wars, this time with the European Union and Japan over autos. Considering the backdrop to slower economic growth in Japan and the European Union, a new trade war could not come at a worse time for them. This is not surprising given the lack of U.S. and European convergence on trade policy vis-à-vis China. Moreover, there are still some loose ends concerning the USMCA (updated NAFTA), such as the need for the national legislative bodies of Canada, Mexico and the U.S. to pass the treaty into law. The U.S. Congress does not seem to be in any hurry in passing the USMCA, which could complicate getting a Sino-American trade agreement from being implemented. We see markets geared to the upside, but as the calendar moves, trade will weigh more heavily on investor sentiment. Investors could continue to look to cash as a safe haven until some of the dust begins to settle.
What’s Coming Up?
The big economic news this week will center FOMC minutes; the Philly Fed; housing (existing home sales and such); and manufacturing. Earnings continue, though we are in the final stretch. We see nothing here that is likely to indicate a major cooling of the U.S. economy.
The Fed minutes are probably the most important item during the week ahead. While the Fed has “paused” on interest rate increases, we will be looking for insights into the U.S. central bank’s willingness to be “patient” as it weighs data and considers its next move. Our view is that there is a good chance the Fed is done with its rate-hiking cycle. U.S. economic data indicates real GDP growth of around 2.5%, ongoing consumer demand and an absence of strong inflationary pressures for the foreseeable future.
The slower pace of growth from 2018 is conditioned by the declining impact of the Trump tax cuts and the likelihood that slower global growth will begin to chip away at the expansion in the U.S. (It could be deeper if a no-deal Brexit exhibits its worst potential.) Most likely this means no recession in 2019 but talk of a recession will exist through the year and increasingly factor into how investors look at 2020. Based on this view, the Fed is likely to remain dovish through 2019, leaving 2020 more open to a rate decline rather than another hike.
Trade will dominate – U.S.-China trade talks continue, which is a positive. President Trump insists far-reaching structural economic reforms need to be part of any “real deal” to end the trade war. The Trump administration has indicated it is willing to delay the March 1 deadline if a deal is close, which would mean avoiding an escalation in tariffs on $200 billion of Chinese imports. We still believe that some type of deal is likely, as both sides need to declare a victory to their bases. A Sino-American trade agreement would also reduce some pressures on the global economy.
The push for a trade agreement comes to a backdrop of another year of lopsided trade between the U.S. and China. According to China, its 2018 trade surplus with the U.S. was its largest in more than a decade, hitting $323.32 billion. Exports to the United States increased 11.3% in 2018, while imports from the U.S. to China rose a measly 0.7%. China’s overall trade surplus was $351.76 billion, the lowest level since 2013, partially due to a 15.8% increase in imports (much of it from other countries). At the same time, China’s economic growth is slowing, which could be reflected by a cooling of imports in 2019. One last item worth note — China’s imports from the U.S. shrank by a record 41% in January, with the trade in soybeans particularly impacted.
Brexit – That sinking feeling: Prime Minister Theresa May is seeking some middle ground on the Irish backstop – anywhere she can find it. At home, members of her own Conservative Party undercut her; the loyal opposition seems lost in trying not to be helpful, while looking like they are concerned. Indeed, Labour, headed by Jeremy Corbyn can almost taste power, but its lack of inspiration, anti-Semite stumbles and party upheaval, leave them behind in the polls.
Brexit threatens to discredit an entire generation of British political leaders who have failed to step up and lead. Instead the UK is marching down an increasingly narrow path which eventually ends in a no-deal Brexit.
The schedule ahead for the UK includes ongoing talks with Brussels (Europeans are finally nervous!). At home, initiatives could emerge from Parliament. One initiative is expected from Labour to prevent May from taking the final parliamentary vote to the wire, by getting her to pledge another “meaningful” vote on her Brexit deal before the end of February instead of March. None of this bodes well. We increasingly believe that investors should be prepared for a no-deal Brexit and a period of policy confusion, as the world’s fifth largest economy disentangles itself from the EU in what has become a very messy divorce.
While London stumbles, the scramble is on: As the Brexit clock ticks down, the UK’s trade partners are scrambling to discern what they need to do. One of the most recent countries to move ahead on this is Australia. Australia’s trade minister, Simon Birmingham, has indicated that his country is preparing for all eventualities in a bid to reduce business disruption. An informal Australian-British working group has been crafting a possible trade agreement for the past 18 months. Agreements with the UK have already been signed or are soon to be signed to ensure the free flow of goods such as wine, medical devices and other manufactured goods after the UK leaves the EU.
The UK is Australia’s fifth-largest trading partner with the two-way trade equal to $19 billion. The UK is also the second largest foreign investor in Australia, after the U.S. Moreover, many Australian companies, such as Macquarie and Westpac, use London as their European headquarters. Australia’s major exports to the UK are gold, lead and wine. One in every five imported bottles of wine consumed in the UK is Australian.
On other fronts, in December 2018, the UK and Switzerland approved a post-Brexit trade agreement. Talks with China and Japan remain at impasses as both Asian countries sense they can gain advantages over a UK pressed for time. Japan has also downplayed the idea of the UK gaining rapid membership in the Trans Pacific Partnership (TPP). If no agreements are in place, the UK and its trade partners will adopt WTO rules, which would be accompanied by an imposition of new, more onerous customs rules and practices. The new rules would function as a major brake on trade, especially with the EU’s remaining 27 countries.
The Global Economic Doctor Brief
February 12, 2019
Dr. Scott B. MacDonald
Sultans, Shahs and Tsars Making a New Eurasia:
The Iran, Russia and Turkey Summit
On February 14, 2019 leaders from three of Eurasia’s major powers are meeting at Russia’s Black Sea resort of Sochi to discuss Syria. This list of luminaries includes the host, President Vladimir Putin, Turkey’s President Recep Tayyip Erdogan and Iran’s President Hassan Rouhani. While Syria is the main focus of the meeting, the summit represents an important development in Eurasian affairs — the increasing convergence of national interests between Iran, Russia and Turkey.
Although this grouping is hardly a close-knit alliance, it provides a counterpoint of sorts to the rise of Chinese power in the East and to Europe, undergoing an identity crisis in the West. It also provides a counterpoint to the U.S., which under the Trump administration has indicated an interest in pulling its troops out of Syria and Afghanistan. To be certain, Iran, Russia and Turkey have different objectives in Syria. But, they have overlapping goals in the rest of Eurasia and all three have strained relations with the West.
The U.S. and the European Union have imposed economic sanctions against Russia for its interference in Ukraine and the annexation of Crimea in 2014. The Trump administration has re-imposed sanctions against Iran and for a brief period it had imposed sanctions against top officials in the Turkish government (later dropped). The costs of sanctions have varied from country to country, but they decidedly hurt Russian and Iranian growth prospects.
Iran has long found itself frozen out of global economic trade and investment for its engagement in terrorism. In recent years, Iran’s economy has been marked by slow growth, rising inflation, high unemployment and mismanagement. President Trump’s decision to leave the Iran nuclear deal (the Joint Comprehensive Plan of Action) negotiated by the Obama administration in 2015 has meant a re-imposition of tough U.S. sanctions against Iran. Iran’s currency, the rial, lost considerable value in late 2018, a development that has made imports, including food, costlier.
While Turkey remains a major trade partner for Europe, they have had a falling out. Turkey’s application for EU membership, initially filed in 1987, has gone nowhere partly due to concerns over the impact of a large Muslim country entering the trade bloc. The increasingly autocratic nature of President Erdogan’s government has also been a point of friction for the EU. When the Erdogan government narrowly averted a coup attempt in 2016, Turkey criticized what it deemed a slow show of support by the West. Consequently, Turkey has moved to improve relations with the east, seeking to gain greater influence in the Middle East and Central Asia. Relations with Russia and Iran assumed greater importance from a trade perspective, though economic sanctions against both of those countries raised challenges.
In Syria, where efforts began in 2011 to overthrow the al-Assad dictatorship, realpolitik brought Ankara, Moscow and Tehran together. A common interest in Syria is the need for political stability.
Iran, Russia and Turkey have already held several meetings over Syria. At the February 14 summit, points of discussion may include removing Americans from eastern Syria and developing a plan for the al-Assad regime to re-establish control over the Kurdish region, which would also have to satisfy Turkish security concerns. This is likely to be a challenging exercise, but the three powers appear to prefer talk, rather than fight, an important development, especially considering their respective historical experiences.
Syria offers opportunities for the Iran-Russia-Turkey relationship. The three countries must carefully weigh outcomes in Syria with the importance of expanding trade and investment relationships and having a more common front against the West. They also share concerns over environmental problems and transnational crime.
What’s next is the Eurasian cabal has to begin negotiating with China. Turkey has been more willing to consider the purchase of Chinese and Russian arms, something that has raised concerns within the North Atlantic Treaty Organization (NATO). Indeed, there have been suggestions that Turkey leave NATO.
While relations have soured with the West, China is another force that has pushed Iran, Russia and Turkey closer. In the early 21st century, China is flexing its economic and political muscles as it seeks to revive the old Silk Roads that linked China and Europe in one vast transportation and trade network. China’s Bridge and Road Initiative (BRI) as well as its Asia Infrastructure Investment Bank are pumping billions of dollars into roads, railroads, harbors, energy and other areas. China’s goal is to transform Eurasia into one large market for Chinese goods and investment.
China has emerged in all three countries as one of the top trade partners; it is the major export market for both Iran and Russia. Equally important, China has pumped considerable foreign direct investment into Iran, Russia and China. According to the American Enterprise Institute’s China Global Investment Tracker, from 2005 to 2018, Chinese investments in and contracts with Russia were $47.2 billion, with energy accounting for $26.6 billion, followed by metals ($5.8 billion) and transport ($2.1 billion). Over the same period, Iran received $27 billion, led by energy at $11.8 billion, and transport at $6.3 billion.
Turkey has also been a focus of Chinese investment, attracting around $15 billion over the same period. Energy (pipelines and power plants) accounted for $9.5 billion and transport was $2.3 billion, including Cosco Pacific’s acquisition of Turkey’s third largest port, Kumport, in Istanbul in September 2015 for $940 million. Turkey is considered by Chinese companies as a logistics hub which could serve as a gateway to Europe and Africa.
The three-nation summit is a quiet signal that Eurasia’s geopolitical landscape is undergoing major changes.
January 15, 2019 — Brief
The Week Ahead
Summary: Markets are looking at a potentially volatile week ahead, but one that might provide a better sense of direction for the next couple of months. First and foremost, the UK's parliament voted against the May government's Brexit plan. This injects further uncertainty into markets, especially in Europe. At the same time, the U.S. earnings season begins in earnest, with the likes of Citigroup, JP Morgan, Wells Fargo, Bank of America and Goldman Sachs showing us their performances for last quarter. The heavy dose from financials should provide us with a little granularity in terms of lending, margins and trading with a look into 2019. The results and outlook could surprise to the upside. Other items on the agenda for next week include a continuation of the U.S. government shutdown, noises about Chinese-American trade talks (which could indicate headway), and a sifting through the implications in California of a filing for bankruptcy by the utility company, PG&E, due to the financial fallout from major fires (an estimated $30 billion in liabilities). Though volatility is likely to dominate credit and equity markets, it appears that for many investors the glass is more half full than half empty due to the Fed's taking its foot off the rate hike gas. Be careful out there, it is still a volatile environment, spiced up with a lot of potential political risk.
Monday’s market was dominated by news that China’s December exports and imports dropped, reinforcing the view that U.S. tariffs on Chinese products are taking a toll on the world’s second largest economy. Trade data on Europe was also disappointing, further showing indicators that global trade is slowing. Concerns over global trade, of course add a degree of nervousness over prospects for global economic growth. This data also puts more pressure on U.S. and Chinese negotiators to reach a new trade deal. If a trade deal is concluded, trade-sensitive companies, like Apple, Boeing and Caterpillar, would benefit as would the automakers, Ford and GM, both of which have a major bet on China.
Perhaps the most interesting item so far this week was Citigroup’s earnings, which were solid. According to the CEO Michael Corbat, “We clearly see a disconnect between what we see in our business and what the markets are saying. We see the biggest risk in the global economy is one of talking ourselves into the next recession as opposed to the underlying fundamentals taking us there.”
And now on to Brexit…
For British Prime Minister Theresa May, Brexit has been a bane as well as the reason she assumed the national leadership in the aftermath of the fateful 2016 vote in the UK to leave the European Union. She now faces what could be the last acts of the drama with a badly divided Parliament as well as her own Conservative Party. Her deal would have provided for a type of customs union with the EU and a backstop for Northern Ireland and Ireland, but it failed. Now, the backstop is to allow trade and people continue as usual in their movement across the Irish border, with a view that further negotiation on this matter would need a longer-term solution.
iShares Currency Hedged MSCI UK ETF
Source: FinBiz. //finviz.com/quote.ashx?t=HEWU&ty=c&ta=1&p=d.
The problem for Prime Minister May is that the House of Commons is more pro-EU than her government. This makes the vote significant in a number of ways. With May’s plan defeated, the UK has no path for what happens at end-March when it is scheduled to leave the EU. If the Prime Minister remains in office, she could attempt to take the UK down a no deal path and risk a severe recession.
What is the most likely outcome? This is the single most important question dogging UK and European markets. There will be a scramble on the part of May to hold her government together, but this could be hard. Other options will be explored, including a new Conservative administration headed by a compromise choice. The problem is going to be that a Plan B may suffer the same type of defeat in Parliament. This leads the UK to the polls, which could favor the Labour Party and make Jeremy Corbyn prime minister. Beyond a strong left turn in economic policy, there is no guarantee that he would be able to deliver a Brexit deal that unifies the country. With that, prospects for a second referendum increase.
But all of that is conjecture. The UK remains headed into uncharted waters that encompass a potential constitutional crisis, a new national election, possibly a new referendum, and confused signals to all of its trade partners, including the EU, the U.S., Japan and China. All of this is likely to maintain negative pressure on the UK’s sovereign ratings and make investors wary of UK securities, except perhaps those looking for bargains with a long-term view. Although the UK’s current political uncertainty and a further downward trajectory of the economy are not green lights for investment, all things, even the Brexit mess, come to an end. All the political froth tends to obscure the fact that the UK remains the world’s fifth largest economy, behind only the U.S., China, Japan and Germany. There has to be some value there somewhere in terms of securities. The UK was there before Brexit; it will be there when it is all over.
The Return of Greece?:
The left-right populist coalition that has governed Greece under Prime Minister Alexis Tsipras since 2015 is struggling to remain in office. The Prime Minister’s party, Syriza, holds 146 seats in the 300-member Parliament and the defection of the government’s junior partner, the Independent Greeks (Anel) with seven seats, is threatening to throw the country into earlier-than-expected elections. The election could also bring back to the fore a number of other issues concerning Greece and the EU.
The issue that could force an early Greek election is a deal forged by Prime Minister Tsipras to finally break the impasse on relations with Macedonia. Greek nationalists maintain that the country to the north will never be allowed to use that name as Greece has sole right to that name in its own region. A compromise was finally worked out between the two countries in which Macedonia would be become North Macedonia. While a majority in the Greek parliament are likely to agree to this, Anel is not and its leader, the Defense Minister, resigned over the matter, hence the political uncertainty.
Although Greece is scheduled to hold elections later in 2019, the North Macedonian vote has brought into sharper focus Greece. The country has come a long distance from its sovereign debt crisis and default, though unemployment remains high (at 18.6% in September 2018) and the standard of living has yet to recover. Opinion polls indicate that if an election were held in the near future, the opposition Conservative Party would most likely win. The vote is planned for Tuesday. We expect that Prime Minister Tsipras is likely to win by the barest of margins, but even if he does not, his government is likely to survive a vote of confidence as most parties do not appear to be ready for an election.
Why do we care? Greece was at the heart of Europe’s economic sovereign debt crisis that brought into serious focus many of the faults within the EU, including the weakness of the organization to make tough political decisions. It also brought into sharp focus Germany’s power within Brussels, which was accompanied by tough-nosed austerity measures. Many Greeks blame Germany for austerity and structural reforms, which also brought about an extended economic depression. Greece is still recovering. Moreover, Greece’s trials and tribulations clearly underscored some of the regional divisions within the EU, especially between Germany and a number of the northern European countries, and southern Europe, namely Greece, but also including Cyprus, Italy, Spain and Portugal.
Greece maintains a degree of importance within the EU for other reasons, including the issue that it continues to have one of the highest levels of debt within the OECD group of countries; has substantial financial needs in terms of infrastructure development; and is one of the frontiers for Europe in terms of migration out of the Middle East and North Africa. Although called a “success story” for Brussels, a considerable amount of damage was done to the country and Eurosceptic groups could be a force in the upcoming May EU parliament elections.
While the debt crisis may have moved along from the financial press, it remains a problem for any Greek government as it constraints economic policy options. It also raises foreign policy issues – as the EU has become tighter in terms of assistance. Countries like Greece have turned to China for foreign direct investment. In 2016 China’s state-owned Cosco purchased a controlling stake in the port of Piraeus, which serves Athens. Chinese investors have also become a force in the purchase of property and Chinese visitors are helping revive the tourist sector. Although Germany and France remain the most significant investors in Greece, China has steadily risen and is now in the top 10 foreign direct investors, pushed along in part by the development of its Bridge and Road Initiative, which seeks to create a more unified Eurasian economic system, girded by railroads, motor routes, airports and ports.
Greece is likely to quietly reappear on the investor landscape as it comes to market with new sovereign deals and heads to an election. At the same time, China’s penetration of the Greek economy and its engagement in the country’s transportation infrastructure raise new questions over how much influence a non-EU member will have on an EU member, something that Brussels may have to give more thought to as it wrestles with the same issue elsewhere in Europe, especially in the poorer regions, like the Balkans.
Venezuela – Another Step Down: Venezuela’s descent from being one of Latin America’s wealthiest countries to one of its poorest is like a really depressing TV series in which each episode takes us deeper into the heart of darkness. We are left with the sentiment that fact is stranger than fiction. The country already has lost an estimated 3 million refugees, one out of every ten of its citizens. And more wish to leave considering hyperinflation, a worthless national currency, out-of-control crime (Caracas is the homicide capital of the world), and scarcities of basic staples (milk, pasta, tampons, toilet paper, and medicines). Adding to the bad news is that Nicolás Maduro, the country’s economically inept president, began his new six-year term on January 10, 2019.
Under the Venezuelan constitution, the president is supposed to be sworn into office before the country’s National Assembly. The snag for Maduro is that the duly elected national legislative body is held by the opposition and it does not regard the President’s re-election in the May 2018 election as legitimate. Although China, Russia, Turkey and other generally authoritarian governments have recognized President Maduro as the legitimate government, the U.S., most of the European Union and Canada have not. Moreover, most Caribbean and Latin American countries have also withheld recognition, the notable exceptions being Cuba and Nicaragua, where leftist regimes rule.
One of the more significant developments was the vote at the Organization of Americans States (OAS), where on January 10, 2019, 19 countries voted “to not recognize the legitimacy of Nicolás Maduro’s new term as of the 10th of January 2019.” Only six countries were opposed. There were eight abstentions and one absent. Among the countries that voted in favor of not recognizing Maduro as head of the Venezuelan government were Argentina, Brazil, Canada, Chile, Colombia, Jamaica, Guyana, Panama and Peru. Mexico made a notable exception.
What makes the OAS vote important is that a president that much of the region considers illegitimate could mean that Venezuelans representing the Maduro government will not be able to enter many countries. Moreover, financial dealings could be thwarted, accounts on foreign soil frozen, and cooperation suspended. While Venezuela is already isolated and increasingly dependent on China and Russia for international support (and much of that tied to Venezuelan oil exports), relations with its neighbors are likely to become even strained.
Increased international isolation is not a positive development for a regime so deeply in economic trouble. Even if oil prices make a rebound in 2019, Venezuela could miss the benefits due to the precarious stance of the oil sector. While Hugo Chavez looted PDVSA, the state-owned oil company, to pay for social benefits, oil prices plummeted in 2014. Making matters worse, most managers and skilled workers lost out in a power struggle with Chavez, who then proceeded to appoint unqualified individuals to head the enterprise. Maduro’s policies continued to gut the oil company of anyone with skills, a situation which has taken Venezuela back to 1950s level of oil production and unable to meet its OPEC quotas.
It is difficult to think that conditions in Venezuela could deteriorate further or, for that matter, that Maduro could remain in power. According to a recent study at Brookings Institute, another 5 million Venezuelans would like to leave. The threat of such a surge of refugees would certainly have an impact on the neighborhood, in particular, Brazil and Colombia. It would certainly impact the Netherlands islands of Aruba, Bonaire and Curacao, Trinidad and Tobago (which is already having issues with the illicit flow of Venezuelans into the islands), and ultimately the United States.
What is next for Venezuela? There are a number of scenarios, ranging from the Maduro regime staggering on much like Mugabe’s Zimbabwe, the fragmentation of the country into warring zones like Libya, or an internal coup launched by the military or security services who have made the bet that Maduro cannot hold the Chavista state together as sources of money become more difficult to find. The last scenario is gaining traction as the economy has fundamentally gone to the barter system and illicit drug trafficking can support only so many corrupt officials.
An external intervention to topple Venezuela’s government is not likely. This threat has been repeatedly used to wrap the President and his court in the Venezuelan flag, but as much as the Trump administration dislikes Maduro, the Venezuelan leader’s own economic mismanagement, aided by targeted U.S. and other countries’ economic sanctions, is more likely to bring about regime change. The only probable case for external intervention would be if the Maduro regime started a war with one of its neighbors (which would be a desperate move and unlikely to be supported by a reluctant military).
Venezuela is now a zombie economy; the government composed of the walking dead. At some point some branch of the armed forces is likely to put it to an end. Until then, it will stagger on, a festering problem for the Caribbean and Latin America and potential worry for investors in the sovereign bonds and other assets from surrounding countries, like Colombia and Trinidad and Tobago.
January 22, 2019 — Brief
The IMF and Growth Issues – Is the Glass Half-Full or Half-Empty?
Summary: The International Monetary Fund (IMF) came out with its revised forecast for 2019, noting that global economic growth was slowing and at a faster rate than expected. The words used in the financial press to describe the forecast were “depressing”, “gloomy” and “sobering”. At the same time, the IMF indicated that world output would slip from 2018’s 3.7% (at the high-end of the recovery cycle) to 3.5% in 2019. We take two things from this. The global economy is not exactly about to plunge into a major recession and there are plenty of things to worry about, hence the downbeat descriptions. The challenge in looking into the global economic glass to see whether it is half-full or half-empty goes to the difficulty in detaching geopolitical risk from strictly economic trends.
Selected World Economic Outlook Projections
Source: International Monetary Fund, January 2019. //blogs.imf.org/2019/01/21/a-weakening-global-expansion-amid-growing-risks/.
The IMF’s warnings are on target. In particular, the Washington-based institution’s worries over trade protectionism and the interlinkages with financial markets is worth noting, “The downward revisions are modest; however, we believe the risks to move significant downward corrections are easing. While financial markets in advanced economies appeared to be decoupled from trade tensions for much of 2018, the two have become intertwined more recently, tightening financial conditions and escalating the risks to global growth.” It does not help that markets are talking themselves into a recession by looking at the worst possible outcomes. Those same policy actions, in particular those surrounding Brexit, the Chinese-American trade war, and Italy’s debt issues, could equally have positive outcomes.
Although it currently feels unlikely that there are solutions for Brexit, the Chinese-American trade war and Italy’s debt issues, time marches on. At some point, the UK will move past Brexit, either leaving the European Union (EU) or maintaining some type of near-membership to that body. Both China and the U.S. could use a trade deal. The Chinese economy is cooling (new data shows that its economic growth slowed to its slowest annual rate in almost three decades) and the U.S. government shutdown could – if it continues for months – start trimming percentage points off U.S. growth. A trade deal on most items and a willingness to maintain ongoing negotiations over intellectual property could help the world’s two largest economies (and help their trade partners).
As for Italy, the government walks a tightrope between its populist rhetoric and fiscal policy. With large payments looming through 2019, Italy needs investors. Tough challenges lie ahead for the Conte government in the face of economic deceleration (the IMF is now forecasting 0.6% real GDP growth in 2019) and the May EU parliamentary elections (during which the populists will use the EU and the European Central Bank as a political punching bag). A weak banking system does not help matters.
Returning back to the IMF outlook, it is important to note that the main part of their downward revision did not come from the U.S. or China, but from the Eurozone. As the IMF stated, “Within the Euro Area the significant revisions are for Germany, where production difficulties in the auto sector and lower external demand will weigh on growth in 2019, and for Italy where sovereign and financial risks – and the connections between them – are adding headwinds to growth.”
The IMF is also forecasting slower growth in emerging and developing economies. They expect to see these economies “tick down to 4.5 percent in 2019, with a rebound to 4.9 percent in 2020.” In 2018, the stronger dollar and rising interest rates hurt developments that countries like Argentina and Brazil struggled through. In 2019, the main culprit in the growth downgrade is Turkey, which is expected to see a large contraction, “amid policy tightening and adjustment to more restrictive external financing conditions.”
The other main culprit for the IMF growth downgrade is Mexico, where growth projections were taken down considerably, related to lower private investment. It appears that the IMF has concerns about the new Mexican government’s populist approach to making that country attractive to investment.
The first half of 2019 will most likely be marked by considerable uncertainty as many of the political issues are resolved. Moreover, policymakers are aware that trade and investment have slowed and that industrial production outside of the U.S. has decelerated. These leave the main risk being a further escalation of trade tensions and a worsening of financial conditions. This returns us back to Chinese-American trade talks and the importance of a deal.
Economic policymakers are looking at a challenging year ahead. There is a lot that can go wrong – a hard Brexit, an Italian sovereign debt crisis and a protracted U.S. government shutdown (which is a real possibility). And there are always the unexpected risks, the black swans that suddenly appear on the radar screens but are difficult to avoid.
So, we take the IMF’s revised forecast not as a dire warning, but a needed wake-up call that policymakers must be ready for major challenges through the year. The global economy is not set to head into a new recession – at least not yet. There remains considerable positive momentum, but compromises will be needed, and greater statesmanship required to get the global economy through what is likely to be a tumultuous first half.
Perhaps the words of South African religious leader Desmond Tutu are apt, “Hope is being able to see that there is light despite all of the darkness.”
January 28, 2019
The Week Ahead
“Fortune always favors the brave, and never helps a man who does not help himself.”
Summary: 2019 has started with considerable momentum, with equity markets bouncing off the bottom in late 2018 and early January and with credit markets finding more stable ground. Yet many of the issues that dogged investors in late 2018 are still very much at play – Brexit, U.S.-China trade, and a faster-than-expected global economic slowdown. However, many investors are looking at the glass being half full rather than half empty, a view helped along by relatively positive earnings. Moreover, the International Monetary Fund’s most recent forecast was based on downgrading Europe’s economic outlook, not that of the U.S. (which is still expected to be at 2.5%). The good news on the U.S. front is that the 35-day partial shutdown of the U.S. government, which is estimated by S&P to have cost $6.0 billion, is over — at least for three weeks while Democrats and Republicans look for a way to find a compromise on a border wall.
While Venezuela’s political crisis is worth watching, there is nothing sudden about the collapse of the Latin American country’s economy. The question has not been one of will there be regime change, but when? Where Venezuela gets interesting is how the country’s political turmoil plays out in international oil markets, which thus far have shrugged off events. But Venezuela sits on top of one of the world’s largest reserves of oil. If conditions deteriorate to the point of fighting over the oil-producing regions in the South American country, the complacency in oil markets could quickly evaporate, especially as sanctions against Iran begin to bite and oil production lags in Libya and Nigeria.
Looking ahead, the major items that we will be watching are:
• The U.S.-Chinese trade talks in Washington: The debate is on — will China’s cooling economy force Beijing’s hand in trade talks with the U.S.? Although the Chinese message at Davos was “stop panicking about our economy’s growth”, it appears that Asia’s largest economy is feeling the pain of earlier efforts to bring under control easy credit made available by non-bank financial institutions (the so-called shadow banking sector) and U.S. tariffs. One can debate what has had the most impact, but the Chinese economy is slowing and this is not good news for President Xi Jinping and his team. January 30’s talks between high-ranking U.S. (led by Trade Representative Robert Lightizer) and Chinese officials (led by Vice Premier Liu He) will give some feel to whether or not the next round of U.S. tariffs is implemented on March 1st. That would see the U.S. hike tariffs to 25% from the current 10% on over $200 billion of Chinese goods. We believe there is room for a deal, but it will come down to the wire. This is likely to be a major market factor.
• The Federal Reserve meeting: While we do not expect to see a rate increase, the Fed’s language and Jerome Powell’s press conference will be very closely watched. The Fed’s mission is to provide assurance over the strength of the U.S. economy, while clarifying it is not going back to aggressive rate hikes. Chairman Powell also must negotiate the missing economic data caused by the U.S. government shutdown and maintain the Fed’s independence vis-à-vis political pressures, such as those communicated by President Trump via Twitter. One last item that will be watched is how rapidly the Fed plans on advancing with the reduction of its balance sheet in the months ahead, which will certainly have implications for the fixed income market. The FOMC meeting on Wednesday should not be a major market event.
• The Med7 meeting in Cyprus: On January 29, the Med7 countries meet in Cyprus. They include France, Spain, Portugal, Malta, Italy, Greece and Cyprus. Attending the summit will be French President Macron, Prime Minister Costa of Portugal and Italian Prime Minister Conte. France, Italy and Portugal have a number of side meetings, while the major issues of the summit will focus on natural gas development offshore Cyprus, the EastMed gas pipeline, migration (a major issue for the countries at the meeting), and the impact of Brexit (which is raising concerns for tourist-dependent economies, like Cyprus, Portugal, Greece and Malta).
• U.S. post-government shutdown politics: Although a three week deal was agreed upon and the partial government shutdown is over, the debate over border security will remain front and center for Congress and the White House. Failure to make headway on the issue, including something for the wall, will leave the door open to another government shutdown at the end of three weeks or possibly the declaration of a state of emergency by the President.
• Venezuela’s political crisis is high on the list of geopolitical concerns, though we do not see any quick resolution of the country’s troubles as long as the armed forces remain true to the fraudulently-elected President Nicolás Maduro and do not defect to the interim president appointed by the elected National Assembly, Juan Guaidó. Any change in government in Venezuela will be the product of an internal process, not an external operation. That said, the U.S., Canada and most Latin American and European governments could opt to tighten economic sanctions against the Maduro regime. The other factor that must be considered is China and Russia, both of which have either lent the Maduro regime money or made investments in the economy. Indeed, Guaidó previously warned foreign companies and governments that their major investments in the country required the approval of the national assembly and that those dealing solely with Maduro were not legally enforceable. China is very sensitive to this considering that a change of government in Malaysia was followed by a review of all deals made by the prior prime minister, who is awaiting trial for corruption. Most of China’s exposure to Venezuela, now estimated at $20 billion, is owed to the China Development Bank and, to a lesser extent, the Export-Import Bank of China. Venezuela owes Russia more than $3 billion, which was restructured in November 2017 to give the Latin American government more time to repay it. Rosneft, a state-owned Russian company, also owns two offshore gas fields and has stakes in five oil assets. The other country embroiled in Venezuela is Cuba, which provides military intelligence services for Maduro as well as doctors for the poor. In return, Venezuela provided cheap oil to Cuba, which met local energy needs and the surplus of which was sold on international markets to help Havana generate revenues. Venezuela does not appear to be weighing on international oil markets, but that dynamic could change if fighting spreads to oil producing areas. In a new Cold War, Venezuela has emerged as a potential hot spot, with Beijing and Moscow having to consider how much their Venezuelan ally is worth.
• Brexit’s unfolding crisis: It took a while, but it is finally being heard within the EU ranks that a no deal Brexit will hurt European workers. This ranges from hotel owners and service people in Spain, Portugal and Malta to French fishermen and German automobile workers. Over the week one German manufacturer stated in Oxy, “No one really believes the U.K. will crash out of the EU with no deal…There is a deep-rooted belief that in the end U.K. politicians will put the economy first. In other words, we are in complete denial.” This comes at a time in Germany when there are growing fears of a possible recession. Over the weekend Ireland indicated that it would not support any changes on the timing of the backstop deal over the Irish-Northern Irish border, which was being floated by the May government to possibly gain support from Conservative Party Brexiters. We expect the upcoming week to be filled with a lot of meetings between the various players in the UK to come up with a viable Plan B. At the same time, there may be more pressure from business on EU politicians to find some path to accommodation. Chances for a no deal Brexit are rising.
The Global Economic Doctor Brief
January 29, 2019
Dr. Scott B. MacDonald
Maybe the glitz of Davos is over
The World Economic Forum, held at Davos every January, has lost some of its glitz. The swank resort in the Swiss Alps hosts an annual event known as a meeting place of the rich and powerful as well as being a beacon for globalization. 2019 was a little bit different as many world leaders failed to show up and many attendees described the mood as “gloomy” or “flat”, especially compared to last year.
Why the downer at Davos? The culprits included the rise of populist politics in a number of European and Latin American countries; a very crowded agenda in the U.S. (government shutdown, ongoing investigations and managing a Venezuelan crisis); and the headache that is called Brexit. This kept France’s President, Emmanuel Macron, the UK’s Prime Minister Theresa May, Canada’s Prime Minister Justin Trudeau and the U.S.’s President Donald Trump away. Certainly for Macron, showing up with the rich and powerful would have been a public relations mistake considering his problems with the Yellow Vests, who are demonstrating against an out-of-touch political leadership and socio-economic inequalities.
The situation was probably not helped by the release of the International Monetary Fund’s (IMF) economic forecast prior to the meeting, which took 2019’s global growth down from 3.7% to 3.5%, largely based on a faster-than-expected economic cooling in Europe. The IMF took Germany’s 2019 real GDP forecast down to 1.3% (from an earlier forecast of 1.9%) and Italy to 0.6% (from 1.0%), both tough cuts to look at.
Probably the most significant spirit to haunt Davos is that of populism. While there is a sense that a number of major economies are in drift mode — Germany, France, Italy and China topping the list — the idea that upcoming elections in Europe could see a further weakening of the mainstream political parties to favor hard left or far right movements, has cast a long shadow. If nothing else, Davos was based on the excitement and grandeur of what globalization brought; populism is exposing the downside of that phenomenon.
The populist spirit certainly loomed over discussions at Davos on the “Fourth Industrial Revolution”, broadly defined as the advance of machine learning and other advanced technology into the business world. For many of those looking in from outside the opulent hotel grounds, the Fourth Industrial Revolution means job losses.
Indeed, companies around the world are actively spending on AI (artificial intelligence) to reduce costs and raise profits. As Mohit Joshi, the president of Infosys, an Indian technology and consulting firm that helps other businesses automate their operations told a New York Times reporter, “People are looking to achieve very big numbers. Earlier that had incremental, 5 to 10 percent goals in reducing their work force. Now they’re saying, ‘Why can’t we do it with 1 percent of the people we have?’”
One of the messages from Davos is that the future for human workers is going to be challenging. According to Kai-Fu Lee, a Chinese venture capitalist, technology expert and author of AI Superpowers: China, Silicon Valley, and the New World Order (2018), it is likely that artificial intelligence will eliminate 40% of the world’s jobs within 15 years. He has also publicly noted that corporate chiefs are under substantial pressure from shareholders and boards to maximize short-term profits, which makes the ever faster shift toward automation unavoidable, despite the loss of jobs.
There are arguments that increased technology is a good thing as it takes workers away from boring, repetitive jobs and opens new vistas of employment. For many of those who have lost their jobs to automation, new technology and its linkage to globalization has left a bad taste. It was certainly a factor in the U.S. 2016 presidential elections and is a factor in driving the Yellow Vests in France in late 2018 and early 2019.
The rise of populism has been stimulated by automation, globalization and the concentration of wealth. All of this is represented by such meetings as Davos, a gathering of the rich and powerful, most of whom want to increase their profits. At least that is how it is seen by many who were not invited to attend. Many of them are now either out demonstrating or voting for populists, who probably do not have the right answer, but offer simple solutions.
The glitz has left Davos and for now that is a good thing. One thing for the billionaires and economic policymakers to think about is that when they return home the world is changing and not all of the trends are positive. Indeed, there are a lot of things going wrong, ranging from the development of a New Cold War, socio-economic upheaval and pressing needs for such basic things as better roads, bridges and airports. As for the Fourth Industrial Revolution, it could well be upended if the world elite does not come to better measure how technology impacts day-to-day life. Erik Brynjolfsson, the director of MIT’s Initiative on the Digital Economy, recently noted, “The choice isn’t between automation and non-automation. It’s between whether you use the technology in a way that creates shared prosperity, or more concentration of wealth.”
Looking ahead to next year’s Davos, perhaps more thought should be given to shared prosperity; otherwise those attending Davos may be confronted by angry mobs carrying pitchforks and crashing the party.
January 22, 2019 — Brief
Europe’s Outlook for 2019 – Headwinds, Ballots and Ratings
Summary: The outlook for Europe in 2019 is a more challenging year than the last, as policymakers confront a combination of slower economic expansion, potential disruption from Brexit, and a series of national and European Union (EU) parliamentary elections. Germany is undergoing leadership change while France is in the throes of a public backlash against longstanding grievances over heavy taxation, an out-of-touch political elite, immigration and socio-economic inequality. There is also a risk that divisions within the EU will become more pronounced between populist-nationalist and pro-EU governments over such issues as freedom of the press, the independence of the judiciary, and what is the proper balance between Europe’s future integration and national sovereignty. The European Central Bank (ECB) remains key to how the economic slowdown will be managed, which means that there will be considerable attention to who succeeds that institution’s head, Mario Draghi, in October 2019.
Although European unity will remain in place and recessionary pressures are likely to be kept at bay, 2019 may see greater pressures on EU institutions and demands for greater fiscal flexibility, which, in turn, could weaken sovereign credit ratings through larger fiscal deficits. Italy and the UK remain the two most significant risk concerns. We would be underweight Europe, but think there are selective credit stories (with good fundamentals) that could benefit those who are willing to stomach periods of high volatility and recognize that there will be a post-Brexit world.
The Economic Landscape
Europe faces stronger headwinds to economic growth in 2019. According to the International Monetary Fund (IMF) (January 21, 2019), the Eurozone expanded by 1.8% in 2018; in 2019 it is expected to slow to 1.6% and to 1.7% in 2020. The driving forces are cooling global trade (due to greater trade protectionism), production difficulties in the German auto sector and fiscal constraints in a number of countries. Italy is facing the most significant economic challenges in the year ahead due to the size of its public sector debt, fragile banking system and concerns over how its populist politics will influence investors. Political risk is likely to complicate economic policymaking in France and possibly Spain. That said, Europe is not expected to head into a new recession. Although exports may slow, domestic demand is set in many countries to pick up some of the slack and global energy costs are expected to remain low.
The European Central Bank (ECB) remains an important factor. Considering that inflationary pressures are weak and show little sign of increasing in the next several months, the expectation is that the ECB will adhere to its forward guidance to keep interest rates on hold “through the summer of 2019”. This is important as raising rates could raise risk concerns over Italy and some of the weaker EU economies through year-end. The ECB also signaled that it plans to end its €2.6 trillion bond-buying program by the end of 2019. If key economies slow at a faster-than-expected pace (which is a possibility), the ECB may have to explore returning to some form of monetary accommodation. This adds to the pressure of the ECB’s leadership transition as Mario Draghi steps down and a new president assumes control to a backdrop of expectant markets.
Selected Real GDP Growth for European Nations
Source: Smith’s Research & Gradings, International Monetary Fund, January 2019.
One of the most difficult factors to gauge in terms of Europe’s economic outlook for 2019 is Brexit. While it is assumed that the UK will exit from its EU membership on March 29, 2019, the unsettled nature of British politics has injected a considerable amount of uncertainty. A hard Brexit (the barest of agreements with the EU) or a no deal Brexit (no agreement in place) would have a dampening effect on European growth prospects. It would most likely translate into a deep recession in the UK, Germany, France, the Netherlands, Spain and Portugal would also feel the impact in everything from tourism to exports. Ireland is the most exposed, with the likelihood of a pronounced slowdown in growth.
Although the situation has yet to work its way out, we think that some type of deal will get worked out before year-end that avoids hurtling the UK and its major trade partners into an economic downdraft. As it is, the Brexit decision took the UK from being one of the strongest growing economics among advanced countries and gave it several years of subpar growth. At some point, the issue must be resolved and a desire for better days has to trump the current state of acrimonious division. Until then the UK will be a drag on regional economic growth. A no deal Brexit could take the UK’s 2019’s real GDP growth below 1.0%, which will certainly have a bite on household spending.
The key economy for Europe remains Germany. From 2014 to 2017 German economic expansion was at a solid pace, being a little over 2.0% on average. Unemployment has consistently fallen, hitting 3.3% as of November 2018. This has helped push along domestic demand. Real GDP growth in 2018, however, was less even, with the third quarter heading into negative territory before returning to growth in Q4 (based on preliminary data). The slower pace of growth in the second half of 2018 came from poorer sales of German manufactured goods to key markets, including the United Kingdom, the United States and China. In this, protectionist policies and Brexit played their part in generating uncertainty. Problems in the auto sector, caused by new pollution standards, also hurt.
Looking ahead, 2019 looms as a more challenging year for the German economy. Although there is a threat of recession related to further pressures on the export front, the most likely scenario is that the economy will continue its expansion. In this, a trade deal between China and the U.S. would be a positive for the Germany economy as both countries are important export markets. Moreover, if China were to slip into a lower mode of economic growth, German exports would clearly feel the pain. (U.S. auto-makers will, for the first time, be able to sell in China.)
The saving grace for the German economy is most likely to be its tight labor market, which should help boost domestic demand. Exports are likely to remain soft and the threat of renewed trade tensions with the United States over autos cannot be ruled out. Other potential headwinds to the German economy, with varying degrees of probability, include another major sovereign debt crisis centering on Italy; a darkening of economic prospects with a no deal Brexit (which would probably take real GDP to 1.0% and push up unemployment); and a further and sharper-than-expected downturn in the Chinese economy. Most of these issues are likely to be worked out without severe economic dislocation, but they remain as risk factors.
Beyond Brexit, Europe’s major economic worry is Italy’s 2019 – 2024 capital finance campaign. In 2019 alone, Italy must sell €226 billion of medium and long-dated debt to a market that remains skittish due to last year’s stand-off between Rome’s populist government and Brussels. What many investors are likely to remember is last year’s Italian-EU spat drove Italian sovereign bond yields to their widest over German Bunds since the Eurozone crisis of 2010-2014. Fortunately an agreement was hammered out, with the 5 Star Movement/League government scaling back their fiscal deficit/spending to a level more acceptable to the EU. A new Italian budget was passed in December.
The debt issue, however, is not likely to go away. Investors remain concerned about the size of Italy’s public sector debt, which is in excess of 134% of GDP. According to the Financial Times, Italy’s total financing needs for 2019 are €376 billion, broken down between €226 billion of medium and longer-dated debt and €150 billion of short-termed bonds. A little over €40 billion need to be financed in May 2019, the month of the EU parliamentary elections, which are expected to heighten political risk in Europe.
The Italian situation is not helped by slowing economic growth. There is considerable discussion in the press that the European Commission will, in its next economic forecasts due on February 7, cut its 2019 GDP forecast for Italy to just 0.6% (which the IMF has already done) from 1.2% in its November projection (effectively halving its outlook).
One of the potential flashpoints for another Italian economic/financial crisis is the banking sector. Although Italian banks claim to have their bad debt under control, the European Central Bank in December 2018 indicated that more needs to be done to avert a slide into another round of problems. Deputy Prime Minister Matteo Salvini (also a leading force among Eurosceptics) attacked the ECB, announcing that the EU’s banking union creates instability in Italy’s financial system and penalizes citizens’ savings. Salvini stated in December, “Transparency is needed to quash the suspicion that the ECB is making political use of its power.”
Salvini’s criticism of the ECB continued in January 2019, when he accused it of again attacking the Italian banking system. He argued that the bank’s request for local lenders to put aside more capital to cover impaired loans could cost Italy €15 billion ($17.14 billion). The ECB is concerned that if the Italian economy slips into a recession (which is a possibility), its banks could see a rise in non-performing loans, which would erode capital adequacy and investor confidence in the sector with investors. In turn, investors are important because they are needed to finance Italy’s large public sector debt and buy Italian bank bonds. Investor refusal to buy Italian bonds could provoke an Italian sovereign debt crisis, which could see ripples throughout the EU via financial linkages.
With the EU parliamentary elections looming in May, we would expect populist leaders like Salvini to continue their attacks against the ECB and other EU institutions. While Italy’s populists are correct in demanding better growth prospects for their country, they risk spooking investors who are needed to refinance their debt. Considering that Italy’s total debt is €2.3 trillion, an inability to refinance raises the issue of default. The threat of an Italian default leaves a major dark cloud over European growth prospects through 2019. Though we think there is only a marginal chance of this, it will dog the markets.
Public Sector Debt/GDP (Maastricht Definition)
Source: OECD, November 2018.
Italy’s debt management issues have an echo in France. President Emmanuel Macron’s efforts to restructure the French economy with an eye to making labor markets more competitive, bringing government spending under control and dealing with environmental issues have run into popular rebellion in the form of the yellow vests, many of whom live in France’s secondary cities and towns and in the countryside. They feel overtaxed, under-benefited and the bearing the brunt of urban elite ideas of how the country should be run.
Starting in mid-November 2018 with demonstrations and continuing through January, the Yellow Vests (gilets jaunes) have forced President Macron to back down on the green-friendly tax on diesel fuel and other measures in order to help the financially challenged parts of the country where many feel left behind. The spark was a proposed fuel tax increase that would have unfairly penalized farmers and rural or small-town inhabitants who lack the public transportation available in the larger cities and depend on their cars and trucks for transport.
President Macron’s efforts to undo the fiscal mess inherited from the previous Socialist administration have left his administration scrambling to readjust fiscally as well as politically. On the fiscal side, he has loosened up some spending, but stuck to other parts of his program. Politically, he has offered a national debate through the good offices of town hall meetings throughout the country. The four main issues to be discussed are taxation, France’s transition to a low-carbon economy, democracy and citizenship (which encompasses the electoral hot button of migration), and the functioning of the state and public services.
Unfortunately for President Macron, the backtracking on government spending is likely to mean that the French fiscal deficit could be in excess of 3.0% of GDP, the EU target. If so, France will have to request an exception from Brussels to “overspend”. Considering that Italy’s proposed fiscal deficit was 2.4% of GDP and they were forced to back down, for France to request and receive a green light from the EU will no doubt cause a degree of political uproar from Italy’s populist government. Moreover, President Macron has sought to make himself the flagbearer of the pro-EU integration camp heading into the spring EU parliamentary elections. In doing so, he has vilified Eurosceptic nationalists, like Italy’s Salvini. We also expect to see the Yellow Vests continue their demonstrations against the Macron administration, which could dovetail into the EU parliamentary elections and maintain pressure on government spending.
Italy and France: Dueling fiscal deficits (Fiscal balance/GDP)
Sources: Organization for Economic Cooperation and Development and Smith’s Research & Gradings.
No doubt France’s and Italy’s fiscal issues will factor into the EU parliamentary elections, putting pressure on a number of governments to loosen their fiscal austerity. It is also a boost to nationalist-populists who can point to the Yellow Vests in France to show it as a place where neo-liberal economic reforms and out-of-touch political elites have forced people to take to the streets.
Politics: A Busy Electoral Schedule
One of the major risk factors for Europe’s outlook is the political landscape, which has a heavy electoral schedule through the year and touches every member of the EU. Even the UK which is set to depart from the EU at March-end could see early elections. The electoral schedule is busy in Eastern Europe, with a major contest looming in Poland (which is highly polarized between a nationalist conservative government and center-left pro-EU opposition). Poland’s election carries more weight than a number of other countries as it has one of the larger blocs of seats in the EU Parliament, has generally been pro-EU (the current President of the European Council is Polish, Donald Tusk), and the country covers much of the EU’s eastern frontier, sharing borders with Russia (Kaliningrad), Belarus, and Ukraine. It has also been one of the stronger advocates of keeping NATO and building up its capacity in the East.
Elections in Belgium, Denmark and Finland will be carefully watched to see if there are any more gains by Eurosceptic populist parties at the expense of more centrist and traditionally pro-EU political parties. Although not scheduled for a national vote, Spain could be added to the list considering that the Socialist Party Sanchez administration lacks a majority in parliament.
Upcoming national elections
Source: Smith’s Research & Gradings
The EU parliament elections are probably the most significant contest facing Europe. The Parliament is responsible for electing the President of the European Commission and has the authority to approve or reject the appointment of the Commission (which proposes legislation, implements decisions, upholds treaties and manages the day-to-day business of the EU). The Parliament also has the authority to force the Commission as a body to resign by adopting a motion of censure.
The elections begin on May 23 and end May 26. A total of 705 seats are being contested, representing around 500 million people from 27 member states. In the past EU parliamentary elections were not considered significant, except in that they were often used as a means to protest standing national governments. In the 2014 elections voter turnout was 42.54%. Generally speaking the EU parliament has been supportive of the European integration process, voted overwhelmingly in favor of pro-integration measures and provided some space for Eurosceptic political leaders to protest and air their views without much consequence.
The upcoming EU parliamentary elections offer the potential to be something very different as significant gains are expected for Eurosceptic parties. Participation is expected to be higher. The number of seats a country receives is based on population size, with the largest blocs being Germany with 96, France with 79, Italy 76, Spain 59 and Poland 52. This breakdown gives considerable importance to the electoral contests in the larger countries.
While Germany and Spain are expected to return a pro-EU bloc of seats to the EU parliament, there is potential for Eurosceptic parties to gain significant representation in Italy, which has a left-right populist Eurosceptic coalition government (5 Star Movement/League); Poland with a strongly nationalist government in Warsaw; and France, where the Macron government is struggling against widespread popular discontent.
Although the pro-EU parties, led by the European People’s Party (EPP), Progressive Alliance of Socialists and Democrats (S&D), and the Alliance of Liberals and Democrats for Europe (ALDE), are expected to remain a clear-cut majority, Eurosceptic parties are expected to make gains, possibly topping a fifth of all seats.
Parties Competing in the May 2019 European Parliament Elections
Source: //www.politico.eu/interactive/european-elections-2019-poll-of-polls/. * Fewer number of seats in the parliament is due to the UK’s departure from the EU in March 2019.
Generally speaking we see more downward pressures on Europe than positive pressures and believe that some countries could see some of their ratings slip through 2019. Europe faces a combination of challenges:
• Slower economic growth;
• Greater pressure to spend from angry populations tired of austerity and social benefit cut-backs;
• Heavy debt burdens that could grow larger.
• An uncertain economic policymaking environment.
• Although generally better than the pre-2008 era, there are still weak banking systems in a number of countries.
What keeps most European sovereign ratings stable are the following:
• Generally prudent fiscal management;
• Prudent debt management and levels that do not function as a drag to economic growth (Italy being an exception to this);
• Well-regulated and transparent banking systems (with some exceptions);
• Despite more competitive political competition from former fringe groups, transparent and open electoral systems and a lack of political violence;
• General consensus on economic systems, though increasing divergence from neo-liberal economic ideas.
• Low inflation;
• Supportive central banks in non-Eurocurrency countries and a track record of ECB effectiveness.
• No major political disputes or border issues between European countries that could lead to military tensions.
On an overall basis, Smith’s regards Europe’s outlook to be non-recessionary, though economic growth is cooling and political pressures could force some deterioration in credit ratings. France and Italy’s ratings are probably the most at risk, though a hard Brexit would hurt UK ratings.
The Global Economic Doctor Brief
February 11, 2019
Dr. Scott B. MacDonald
Too Much Divergence is Not a Good Thing
On February 7, 2019 the European Commission (EU) released its economic growth forecasts for the European Union. The news is not good. The European economy (both defined as the EU 28 and Eurozone 19) are slowing at a faster-than-anticipated pace. Although the word “recession” was not used, the combination of weaker demand for exports from China, the increased likelihood of a no deal Brexit (and all that it implies), and a busy EU electoral agenda could mean that sentiment remains negative on Europe’s prospects though the year. A weak European economy is not good news for the global economy, especially as China’s growth is also questionable. That leaves the U.S. economy as the only major economy in strong growth mode.
The key points of the European Commission’s announcement were:
1. The EU has cut the strength of its 2019 growth forecasts for the entire area. The Euro Area was taken down from 1.6% to 1.3%, a significant drop driven by weaker Chinese demand, uncertainty over Brexit forcing companies to hold off on capital expenditures, and domestic political problems (like the Yellow Vests in France and fiscal policy and politics in Italy). There are also concerns that the U.S. could move later in the year to impose tariffs on autos;
2. Germany and Italy suffered the biggest cuts. Germany’s outlook was “a result of weakening export growth and disappointing private consumption growth, despite the buoyant employment situation.” Additionally, there were “bottlenecks in environmental certification in the automotive sector, which led to a pronounced decline in car purchases.” Italy’s outlook was grimmer, with the economy falling into a technical recession in the second half of the year. Italy has been hurt by sluggish domestic demand, a situation compounded by uncertainty and rising financing costs. Indeed, Italy’s monthly industrial production for December fell 0.8% from November, the fourth consecutive month, contrary to a 0.4% consensus by a Reuters’ poll of economists.
3. European businesses remain cautious over the political and economic landscape, driven by concerns over Sino-American trade negotiations, Brexit and European elections. Voters go to the polls this year in Denmark, Poland, Finland, the Baltic States, and for the EU Parliament. All of this has led to some hesitancy in capital spending, a development that could extend through 2019 and into 2020.
4. For the UK, the European Commission’s forecast “is based on the purely technical assumption of status quo in terms of trading relations between the EU and the UK.” In other words, the forecast does not take into consideration any disruption in trade, possibly caused by a no-deal Brexit. Our assumption is that a no deal Brexit (which is increasing as a possibility) stands a very good chance of pushing the UK economy into a recession in 2019 and would make 2020 a tough year. It would also have an impact on the rest of Europe. The EU elite may not want to give any ground to the May government for new negotiations, but they could be setting their citizens and economies up for an economic shock if no deal is struck.
5. The European Commission also noted that “the risk of sovereign-bank loops persists, even if they seem currently less pronounced in the context of generally low sovereign yields.” This points to the problematic nature of Italy’s debt burden, its heavy dependence on investors to finance that burden, and the weakness of the country’s banks. We would add to this that if Italy’s ratings were to slip to junk, the ripple effect in Europe would be substantial, considering the wide range of exposure throughout the EU’s banks, pension funds and insurance companies. Italy is currently rated Baa3 (stable)/BBB (negative)/BBB (negative). Many of these institutions cannot hold non-investment grade debt, which means Italian debt could be dumped — this would only aggravate the crisis.
We would add one more item on the worry list for Europe: Potential problems could be brewing in a number of banks, in particular the two large French banks, BNP and SocGen. Both banks saw the stumbles of their German rival, Deutsche Bank (now being thought of as a merger candidate with that country’s other large bank, Commerzbank), and sought to expand their business range, including into equity derivatives. While equity derivatives provided income during years of low stock market volatility, the shift to higher volatility in late 2018 changed the game. According to Bloomberg, a series of trades in BNP’s New York offices went poorly around Christmas and lost $80 million, helping send Q4 stock-trading revenue plummeting 70%.
Equity derivatives also played a role in dampening SocGen’s Q4 performance. French banks have been regarded as some of the strongest and more profitable in Europe’s banking system. No longer. According to long-time bank analyst from Viola Risk Advisors David Hendler, ”They’ve been ramping this stuff up because it’s easy money to make when volatility is low. They have false confidence that they can trade their way out of problems and they didn’t, both of them.” This could be an area to watch going forward into 2019, adding one more risk factor to Europe’s banking system. Hendler believes that the French banks are going to be increasingly dogged by problems in their equity derivatives businesses, which could also bring into question the nature of derivative trading by other large European banks.
The U.S. economy looks strong in contrast to the dark clouds hanging over the European economic landscape. While there are problems, such as a deteriorating fiscal picture and rising debt (with the debt ceiling issue looming in a few weeks), real GDP growth appears set to roll along at 2.5% for the year, unemployment is at 4.0% (and could be teased a little lower through the upcoming months); and the corporate sector is still enjoying solid profits. The financial sector also appears to be in relatively good shape and one of the first major bank mergers, between BB&T and SunTrust, was just announced, pointing to the possibility of more consolidation. Looking into 2020, the IMF is calling for the U.S. economic expansion to continue, albeit it at a slower 1.8% pace as the benefits of the Trump tax cut wind down.
A cooling Europe is not likely to sink the U.S. economy in the short term, but it is a worry. Indeed, Europe is more fragile than the numbers let on and there are a number of potential triggers that could push the region into a recession. Any major financial disruption, perhaps caused by Italy losing its investment grade ratings or bigger losses at the French banks (and possibly others) due to equity derivatives, would run the risk of contagion to U.S. markets. And a sharp divergence from the U.S. on the growth front is not a positive development over the long term as it would ultimately dampen U.S. growth prospects.
The faster-than-expected cool-down also has put the European Central Bank (ECB) on notice. It will have to give careful consideration to what it can do to help maintain a supportive stance and rebuild confidence. In December 2018 the ECB announced it was ending its four-year campaign to buy bonds (quantitative easing), of which it acquired around $2.5 trillion. Considering the economic slowdown, plans to return policy back to normal and raising rates probably will remain on hold for the foreseeable future. Elections will complicate the situation.
In early 2019 Europe’s economic policymakers have their work cut out for them.
The Global Economic Doctor Brief
February 11, 2019
Dr. Scott B. MacDonald
The Week Ahead
Summary: January was the best start to a year in the stock market since the 1980s; it will be tough for February to top it. We expect more volatility in the weeks ahead, considering the heavy calendar of data releases. At the same time, interest rates are going to remain low, which is a positive considering heavy debt loads racked up by governments, companies and households.
What’s Going On:
Key Dates and Data:
Italy — We believe that Italy will be more in news through the week as the impact of its new recession sinks into investor considerations.
Italy’s GDP Growth Rate (quarterly basis %)
Japan — We will also get a fair amount of data out of Japan in the upcoming week, including GDP for Q4. If the economy shows another quarter of contraction, following Q3’s disappointing performance, Japan could technically be in a recession. This could add to worry over the global economic slowdown.
Japan GDP Growth Rate
The weakness in the Japanese economy is evident in corporate earnings. According to SMBC Nikko Securities, 1,014 companies in the benchmark Topix index reported Q3 (part of a fiscal year that ends in March) operating profit that was 2.6% lower than the same quarter last year. This was the largest percentage decline since the 2011-2012 fiscal year when the March 11 earthquake and tsunami disrupted supply chains worldwide. The key drivers for the cooling of Japanese corporate profits was the slowdown in the Chinese economy, which has hurt both tech and auto companies.
Adding to concerns over Japan’s economy, bank profitability was hurt by the Bank of Japan’s negative interest rate policy. More concerns over a slow return to stronger bank profitability came with a note from Morgan Stanley’s economists, who revised their call when the Bank of Japan will move from negative rates back to zero; the earlier forecast was for April, in consideration of a sharper-than-expected slowdown, the call is now for October. The IMF is forecasting 1.1% real GDP growth in 2019 and 0.5% in 2020.
The Week Ahead
Iran, Russia & Turkey Summit
The Week Ahead
IMF and Growth Issues
The Week Ahead
Europe’s Outlook for 2019
EU Economic Growth
The Week Ahead
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