The UK’s vote to leave the EU boosted the activism of the central banks, which are keen to stave off any slowdown risks and liquidity accidents. While this activist approach should continue to shore up markets in the short term, there are many potential economic or political pitfalls.
We maintain the cautious view of the global economy outlined in our previous reports. As we predicted three months ago, the main central banks have acknowledged the renewed weakness of the global economy. Consequently, the US Federal Reserve has suspended its monetary normalisation; the ECB, already embarked on an aggressive QE process, constantly asserts that it may do even more; and China has combined yuan depreciation with a significant fiscal stimulus package. Only the Bank of Japan has yet to launch any new initiatives, preferring to step back for a while to assess the effectiveness of decisions already taken.
The UK’s vote to leave the European Union was the main event of the past quarter. It triggered a fall in sterling of about 10% against the main currencies. It also boosted the activism of central banks, which are keen to stave off any slowdown risks and liquidity accidents. Mario Draghi’s interventionist statements have been matched by efforts from the Bank of England, which is anxious to offset the negative impact of the referendum decision on growth and capital flows. The vote in favour of Brexit has also reduced the probability that other presumed candidates might seek to leave the Eurozone by finally launching a debate on the economic consequences of such a decision. In the Spanish parliamentary election, held three days after the UK’s referendum, the anti-establishment Podemos party failed to make the expected breakthrough. With great zeal, the watchdogs of European construction duly executed their mission to demonise any troublemakers.
Optimists may now hope that upcoming elections in Italy, France and Germany will allow politicians to emerge who want to introduce more democracy into the EU bodies; this would be the best way to reconcile continental and island views of the European project. The tightening of government bond spreads after the shock reflects the paradoxical impact of the UK vote which, far from opening a Pandora’s box, seems instead to have strengthened the cohesion of the rest of Europe, supported by a renewal of activism among the European central banks whose interventions have been given added impact by the tragicomedy of Brexit. The markets will choose sides: instead of seeing the activist monetary policies as a fatal headlong rush, they may start to discern the promise of still more generously valued assets.
Leaving the impact of Brexit aside, the European economy is little changed from the situation we described three months ago. While France seems to be continuing its efforts to address the cyclical disjunction caused by the fiscal overkill of 2012-2013, the underlying indicators of German growth are showing signs of weakening.
In France, growth has been supported by a clear rebound in corporate margins, which could stimulate investment spending. In Germany, strong consumer spending, which has been compensating for the sluggish foreign component (weakened by a lack of growth in global trade), looks less certain, in our view. The firming-up of consumer spending was mainly due to disinflation, as indicated by the fact that real retail sales growth has been outpacing nominal growth. With no German moves to encourage consumer spending, growth in the rest of Europe would inevitably be affected.
The situation of the UK is worrying in the very short term. The British economy, which is highly dependent on (especially financial) services, faces a threat to its financial pre-eminence in Europe from the loss of its euro-denominated clearing activities and the authorisation to market its financial products in the rest of Europe, as they stand to lose their European “passport”. A diminishment of the financial sector would be accompanied by a fall in the London property market and capital outflows.
At the macroeconomic level, the current-account balance, which already shows a deficit equal to 5% of GDP, will go further into the red as the services component - the only sector showing a surplus - weakens. The UK’s situation represents a destabilising factor for the European economy, but it could subsequently create new opportunities for alternative financial markets. Against this backdrop, is it possible to envisage a less radical outcome of Brexit than that provided for in the treaties, given the gloomy economic prospects for the United Kingdom, the major political crisis threatening the future of the UK’s internal union and the loss of a key member of the European Union?
This question reflects the political and economic uncertainties that will beset Europe over the coming months. But that fact that European bond yields are below zero, leading to an exodus of investors towards more lucrative assets, should support risk assets until negative rates start to present more disadvantages than advantages. Pension funds, insurance companies and, of course, banks are already being hit by the negative remuneration of cash. The Italian banks, as well as some of their German peers, may soon appeal to the markets once again. Europe will then need to switch to a policy of fiscal expansion, more focused on growth, which unfortunately only a new crisis will legitimise in the eyes of European decision-makers.
The situation in the United States is one of rare stability. Economic growth continues to average around 2%, helped by consumer spending growth nearing 3% thanks to a lower savings rate. The strength of consumer spending could nevertheless be tested in the months to come by signs of fatigue in the labour market: a fall in the level of job creation and a modest rise in hourly wages but offset by a drop in the number of hours worked. The discreet but persistent inflationary pressure driven by costs is eroding purchasing power and constitutes a future slowdown factor.
Moreover, investment in production, the determinants of which remain weak (companies’ margins down over the last four quarters, low capacity utilisation rates, sluggish orders for durable goods), remains soft, as does residential investment, whose most relevant advance indicator is sliding dangerously: annual growth in building permits recently slipped into negative territory. Even though the rebound in the leading activity indicators (ISM) forces us to be cautious in our forecasts, the underlying weaknesses of the economy could materialise at a time when electoral uncertainties are at a peak.
The presidential election, in which an unpredictable outsider faces an establishment figure whose probity has often been questioned, creates plenty of opportunity for surprises. We still think that sluggish equity markets and slower economic activity will create the conditions for an expansionary fiscal policy by a still accommodative Fed. Both presidential candidates have shown sympathy with Keynesian ideas. As a result, the US presidential election is as much a source of short-term anxiety as of medium-term investment opportunities.
The emerging market universe is also taking advantage of the dollar’s lack of strength, partly caused by the halt in US rate hikes. Commodities exporters are benefitting from better prices. North Sea Brent has appreciated by 90% from its low, iron ore by 56% and copper by 16%. In Brazil, despite political problems, the situation is stabilising, while in Russia there are glimpses of the end of the tunnel.
In China, capital outflows are much lower than during the August 2015 to March 2016 period. This renewed calm has enabled the authorities to continue their orderly devaluation of the yuan. Thus, the Chinese currency has lost around 9% compared with a basket of currencies representative of its commercial trade.
This exchange rate policy, coupled with public spending growth of around 25% in response to the ongoing decline in private investment, which is growing at no more than 4% year-on-year (vs 50% in 2011), enables economic growth to remain between 5% and 6% and industrial production growth to stabilise at around 6-7%. The quality of this growth is deteriorating, but in the absence of major external shocks, the authorities seem capable of prolonging the exercise.
Finally, India, the star pupil of the emerging world, is set to lose its virtuous central banker. It seems that the authorities want the central bank to be more focused on growth and less worried about inflation. In India too, the imperatives of immediate growth seem to have won out over the hopes borne by a virtuous policy mix with a medium-term focus.
Even if central bank intervention should continue to shore up the markets in the short term, there are a plethora of potential economic and political pitfalls. Given the perverse effects, which are becoming more identifiable, of monetary policies based on very low or negative rates, it seems logical to expect the fiscal weapon to be deployed, supported by accommodative monetary policies.
Whether in Europe or the United States, it is likely that this double-trigger weapon will only be activated in the event of express need, created by economic turbulence likely to prompt a banking crisis for example, unexpected consequences of Brexit, or just a weakening of the economic climate.
As far as equities are concerned, our global investment strategy remains constructive for the immediate future. Equity markets are still protected by the central banks, whose interventionism, coupled with a return to moderate inflation fed by the pickup in oil prices, is creating an environment of negative real rates. We maintain our relatively high exposure to high-visibility investment themes with low exposure to the economic cycle, and remain particularly vigilant with regard to the risks building up.
On the interest rate front, we believe that the risk/reward offered by government bonds no longer justifies a strong position in terms of modified duration. Carefully selected European corporate bonds continue to offer value, thanks notably to the actions of the ECB.
The forex market offers mainly sporadic opportunities. The weakness of sterling seems to have become structural, justifying a lack of exposure in our portfolios. The yen remains a hedge against risk aversion. The Japanese currency, as we expected, has provided the best hedging strategy over the past quarter. As for the euro/dollar exchange rate, we think that the contradictory forces acting on it are likely to prevent any great movement in the short term, although we maintain our longer-term favourable view of the dollar, a safe-haven currency in a world that is increasingly fragile.