It’s been a busy week already with OPEC announcing its first production cut in 8 years, the usual monthly US employment report and the build up towards the Italian referendum this weekend. These are all important factors in a world where politics is changing and markets are moving fast as investors change their positioning to adapt. Although we are comfortable in our structural views that mainstream assets will provide very disappointing returns over the next 10 to 12 years, anything can happen in the short term, as 2016 clearly illustrates.
Ahead of the UK referendum in June, the consensus was very much that a vote to leave the EU would be bad UK markets and probably global markets as well. Apart from a few days of volatility, markets performed better than expected. The situation was not dissimilar ahead of the US election, with consensus happy to believe that a Trump victory would be a disaster. The US equity market has actually been pretty robust at the index level, although bonds and non US assets have been mixed. Out of both events, there have been winners and losers in the financial markets, but our point is that the worst fears have definitely not been realised.
So, with a likely NO vote in the Italian referendum, will we see an immediate problem in the Italian bond market and the banking sector? We suspect not. Reports in the press indicate that the ECB stand ready to buy as many Italian bonds as necessary to make sure that those nasty bond vigilantes don’t get their way. There is also the likelihood that, assuming PM Renzi does step down, the political system does not descend into chaos immediately. Surely there will be an attempt to form a caretaker government until elections will be held sometime later.
So although we (and others) can build a scenario whereby a NO vote could easily throw Italy into chaos, thereby putting serious pressure on the European project, we are strangely relaxed about this potential. This is not to say that we are any less bearish about the European project per se, it’s just that we can easily envisage another “extend and pretend” exercise.
Of course, the problem with the ‘extend and pretend’ solution is that the underlying ailment does not get treated and is left to fester until it becomes an even bigger and more urgent problem. There are serious problems to tackle in the Italian banking system and the country is massively indebted, and to have any chance of keeping voters happy, these problems need to be addressed and growth needs to be a lot higher. The issue here is that Italy has simply not grown at all within the construct of the Euro which was launched in 1999 (see chart 1 below illustrating productivity), and the demographics (immigration aside) and structural problems indicate that potential growth is currently somewhere near zero.
Chart 1 – Productivity in Europe and selected countries
Any extend and pretend response to a NO vote in Italy will only buy a limited amount of time which may well be wasted by Italian and European politicians. The Euro is not working for Italian workers and voters as it is not for many in Greece, Portugal and many other parts of Europe. Incumbent politicians are desperately hanging onto the status quo which looks more and more like fiddling whilst Rome burns. Unless Europe sees radical change, the ‘extend and pretend’ status quo will be at risk of collapse.
Elsewhere, the OPEC production agreement, having been reasonably well flagged, was still a positive surprise for the oil price which rose by nearly 10% on the day. Although cheating on quotas is highly likely, we think this agreement is important in at least two ways. First, having chosen to stand aside from price targeting at the end of 2014, OPEC has managed to co-ordinate an agreement which should support the oil price in the $40s all other things being equal. Second, there has been an agreement with Russia and other non OPEC producers to cut production as well. Involving Russia gives the OPEC cut more importance in terms of price support. It also gives Russia a say at the negotiating table, which in a world of heightened and relatively fast moving geopolitical developments, is not necessarily a good thing.
For mainstream financial markets, the OPEC cut and subsequent rise in the oil price has been seen as adding to the reflation narrative that has been building for some time and has gathered speed since the Trump win. We have no issue with this narrative in the short term. There are at least two potential issues that we are trying to get our heads around. First, will a more robust reflation narrative encourage the Fed to be more aggressive next year in raising rates, and if so, will we look back and view this response as a policy error? Second, assuming the OPEC move raises the price of oil towards $60 over time, and assuming US Shale production ramps up, will this bring forward the day that the US is energy self-sufficient? If the answer to both these questions is yes, then the implications for investors could be profound.
We won’t go into detail again here as we have spent a lot of time recently discussing the potential for either an elegant reflation or a darker path to reflation. To put it another way, could the current upswing be a late cycle phenomena, and if so, could a more aggressive Fed response actually push the US into recession late next year. Should that occur, we believe it would be extremely bad news for equity markets and lower quality corporate bonds and most likely damaging to the Fed’s credibility.
US energy self-sufficiency, if this was close to being achieved, would be potentially positive for the Dollar and bad news for the rest of the world. Again, we won’t go into detail here as we have covered these dynamics in the past. With so much global trade conducted in Dollars, for the global economy to generate growth, the US has to supply a steady flow of Dollars into the global system. Historically, this was achieved by the US running a current account deficit. For the most part, the US runs a deficit in both consumer goods and energy, and it was the waxing and waning of the economic cycle and that dictated the size of the US’ current account deficit and therefore the supply of Dollars into the global system.
However, something changed post crisis, as even though the US economy has recovered, the US current account deficit has stayed pretty steady at around $120 billion a quarter. Without the natural increase in Dollar supply that would normally have occurred with a US economic recovery, the shortfall was initially covered by the Fed's QE, which supplied Dollars to the global system via the capital account rather than income account. This dynamic is set out in the chart below from our friends at MI2 Partners.
Chart 2 – US current account and Global GDP
What we are trying to get our head around is that the US Dollar will be strong because of higher US yields in response to the Trump reflation policies that are goosing an economy that is already a bit stronger than 1H 2016 added to more insular trade policies and possible repatriation of trillions of Dollars from corporate profits held abroad. If we add on top an increase in US oil production as the oil price moves above $50 and towards maybe $60, then a shrinking current account deficit should act as a headwind for global growth and potentially make the Dollar more attractive especially relative to emerging market currencies.
These thoughts on a potential Fed policy error and outcomes post the OPEC production cut are intriguing in the medium term, and we will try and work on these in the weeks ahead as developments play out. As noted above, in the short term, anything can happen. Although it looks like the post Trump reflation trade as measured by rising yields, equities and the Dollar appears to have lost a bit of momentum at the end of last week, we do think there is more to go into year end and beyond, especially for yields and the Dollar.