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ASSET ALLOCATION - ECB, Fed, Trump, Renzi, Rajoy, and Brexit. Which are the game changers… if any?

THE ESSENTIAL

 

A few key points are emerging as the summer draws to a close.

Global growth is not picking up - but neither is it weakening. It remains driven by domestic demand, and global trade has lost some of its importance. Monetary policies will remain accommodative overall: declining rates in the UK, continued QE in the eurozone and Japan., whereas the Fed is still far from normalising its interest-rate policy.

Inflation remains under control, including in the US, despite a rise in wages.

Long-term rates are still anchored low, specifically in zones where the central banks are buying up assets (Japan) or well above the amounts of net issues (eurozone).

The search for yield and spread is the driving force in investment.

With low rates and satisfactory growth, the valuation of risky assets cannot help but stay high.

The rise in oil prices is generating interest in commodity currencies.

Taking advantage of this are several emerging markets, which have the edge due to attractive valuations and the return of capital flows.

Stay selective: on the emerging markets (a few specific risks) and in Europe (upcoming elections or current political deadlocks). In other words, even though valuations are attractive, there is still great divergence in terms of risk and perceived risk.

The political deadlock in Spain is at least as much of a risk as the forthcoming Italian referendum. The ECB is protecting Italian debt and Spanish debt, but at this time, the Spanish risk may be underestimated, while we consider the Italian risk overestimated.

Certain risks have receded (the Fed's monetary normalisation, China's hard landing, end of QE in the eurozone); others are stable (Brexit impacts). Conversely, political uncertainties have edged up: this is true for Spain, Italy, France… and the United States, even though there is less and less of a chance that Trump will accede to the US Presidency.

 

PUBLICATION

 

August was a calm month on the financial markets: no shock in the US, slightly better in the emerging countries, decline in the stress that bubbled up after the UK referendum. The MSCI Indices remained stable overall (+0.2% for the MSCI World, +0.5% for the MSCI Europe), and only the emerging countries index outperformed (+3.2%). European equity market indices also moved little, unchanged in France and Italy, and rising moderately in Spain (+0.8%) and Germany (+2.4%). Note, however, the significant rebound in the price of oil (Brent rose by 18% to $50 a barrel), and the rise in long-term rates: +16bp for the US 10Y (1.60%), +8bp in Germany (-0.04%), and +13bp in Japan (-0.06%). The British 10Y was back near 0.55% (-12bp).

This lull should not mask the current risks, but neither should it be considered an anomaly. As always, questions remain. We think seven of them are crucial at this stage. They were discussed at our most recent investment committee meeting:

QUESTION # 1 Will the ECB extend its QE programme beyond March 2017, or will it prepare the financial markets for a phasing-out?

QUESTION # 2 Can the ECB decide to buy equities or bank securities?

QUESTION # 3 Will the Fed continue its mini-cycle of monetary tightening in 2016?

QUESTION # 4 Will the Italian referendum result in Matteo Renzi's resignation and trigger another political crisis in Italy?

QUESTION # 5 Is Spain headed for a political crisis?

QUESTION # 6 What will happen if Donald Trump becomes President of the United States?

QUESTION # 7 Will the United Kingdom trigger Article 50 to exit the EU? And if so when?

 

QUESTION # 1

Will the ECB extend its QE programme beyond March 2017, or will it prepare the financial markets for a phasing-out of its programme?

The economic and financial situation in the eurozone has improved dramatically since the ECB took things in hand via its unconventional programme. Specifically, this controls volatility and ensures better solvency for European States (fewer financing conditions, and the systematic and ample presence of an institutional buyer, the ECB). Indeed, knowing that the European Central Bank will purchase much more than the net issues of all European governments is enough to reassure shareholders, and playing against the ECB becomes a dangerous game. More open to debate is whether interest rates will move into negative territory, specifically concerning banks' profitability: nothing is worse than low or negative rates and ultra-flat rate curves, as is currently the case. Given that the banks are also still dealing with a high cost of capital, this measure is inadequate. In addition, the banks have been relentless in depositing liquidities at the ECB, and these amounts have now exceeded the €1 trillion mark (compared with just over €100 billion when QE was rolled out). Betting on new rate cuts no longer makes any sense at this stage. We think it is clear however, that the ECB will announce (no doubt in September) that QE will go beyond March 2017 and probably cover all of the year to come. Moreover, this will mitigate the political risks that are emerging (see below).

QUESTION # 2

Can the ECB decide to buy equities or bank debt?

The ECB purchases government bonds, Investment-grade corporate bonds (except bank securities), and ABS, and this has a negative impact on liquidity on the fixed-income markets. This is so true that it seems unwise to bet on rates being raised in such an environment. It is increasingly complicated to continue purchasing when certain governments have stopped or reduced their issues of paper, which is why the idea is floated by some (aware of this finding, and considering that the Bank of Japan is following the ECB's path) that purchasing equities or senior bank debt is becoming inevitable. We are not counting on it. It is no longer the ECB's aim to buy assets per se, but to weigh in on the behaviour between savings and consumption on the one hand, and remodel savings (or its structure) on the other (on this point, see « Searching for the savings accelerator / multiplier » P. Blanqué - Ph. Ithurbide July 2016). Yet European household savings are not "rich" enough in equities for such a measure to be effective. As for bank debt, until now, it was excluded from the QE programme. The ECB took the role of providing the banks with liquidity (TRO, LTRO) and facilitate their (low-rate) financing, not supporting them directly, given the close link between banks and government bonds and the moral hazard risk that would be inherent in purchasing bank debts. We find the ECB's attitude to be extremely consistent, and we maintain that deviating from the current approach would be dangerous and counter-productive.

QUESTION # 3

Will the Fed continue mini-cycle of monetary tightening in 2016?

For the past several quarters, the Fed has regularly prepared the financial markets for rate increases. It has repeatedly adjusted its posture, in light of the Chinese situation, volatility peaks, or undesirable distortions on currency prices. J. Yellen and S. Fisher, the Fed Chair and Vice-Chairman, are back in this stance, and there is good reason to believe that they will take action before the end of the year. We are refraining from using the terms 'normalising' or 'monetary cycle'. The Fed will remain extremely gradual, and extremely conservative. Yet it cannot be denied: little by little, key interest rates are on the rise. However, none of this is cause for a shock on the bond markets. True, wages are increasing, but inflation remains contained, specifically core inflation. In addition, the pace of job creation is down right now, and unemployment has checked its fall. Preliminary indicators argue for growth near 2% - no more. In other words, there is no urgency for the Fed, and a too-aggressive monetary policy would probably generate more risk of a dip in growth, an excessive risk with regard to the current (relatively weak) risks of inflation. In sum, our central scenario where the Fed is concerned is an increase in rates in late 2016, and a further increase in 2017.

QUESTION # 4

Will the Italian referendum result in Matteo Renzi's resignation and trigger another political crisis in Italy?

The elections in 2016 and 2017 could indeed put new leaders centre stage in a good many countries: Germany, France, Italy, and Spain. Given that there will soon be a new president in the United States, and that for the past few weeks, a new prime minister has been at the helm in the United Kingdom, we are taking stock of the changes that are going to impact Europe. Contrary to other countries, Italy is not in the process of readying for general elections, but for a referendum.

Reminder of the political calendar in the European Union

The ECB is protecting the bond markets from political risks, which is a good thing in light of the packed political calendar in Europe.

  • Referendum in Hungary on immigration quotas, 2 October 2016
  • Presidential election in Austria, initially planned on 2 October 2016. Probably postponed to 27 November or 4 December
  • Referendum on the constitution in Italy, to be held between November 15 and December 5
  • General elections in the Netherlands, March 2017
  • Presidential elections (23 April and 7 May 2017) and legislative elections (11 and 18 June) in France
  • General elections in Germany in the autumn of 2017

We have covered here the most immediate events (Spain, Italy, US). We will not fail to analyse the two major events of 2017 - the French and German elections - as quickly as possible.

 

The Italian referendum is essentially on Senate reform (for more details and a complete analysis, read Article 3, "Key elements of the Italian referundum").

There are four possible scenarios:

  • Scenario 1: a vote for reform, and Matteo Renzi stays in office as prime minister. Without a doubt, this is the best-case scenario: there is no political crisis, the government is stable, reforms continue, and European countries are satisfied.
  • Scenario 2: a vote against reform, Renzi steps down, and preparations are made for another round of general elections: the worst-case scenario, which may lead to political instability/crisis and certainly cause any reforms to grind to a halt.
  • Scenario 3: a vote against reform, Renzi steps down, and a new technical government is put in place: an unpleasant scenario, because the new government would probably see it as their mission to put constitutional reform first. Italy downplaying new reforms and beating a political retreat would be harmful in terms of perception of the political risk.
  • Scenario 4: a vote against reform, and Matteo Renzi stays in office as prime minister. Just a few weeks ago, this scenario was improbable, because the Prime Minister had himself announced his resignation and the end of his political career if the reforms were rejected. He has since reconsidered, because his fate does not have to be tied to a Senate reform, and also, probably, after discussions with his European partners (Germany and France in the lead), who want to keep a quality front man like Renzi (constructive and reform-minded) in place.

We cannot make any predictions about the way the people will vote. We can only rely on the polls. But it does seem to us that the likelihood of Matteo Renzi staying in office (whether the vote is for or against reform) is high. In other words, we are probably not headed for a phase of instability/crisis/political chaos. That is good news for this country, which is behind in terms of economic growth (in comparison with Spain, its "comparable" on the markets), but whose debt is protected by the ECB and continues to attract investors (looking for yield and spread).

QUESTION # 5

Is Spain headed for a political crisis?

Spain is in a deadlock. In late August, Mariano Rajoy did not win a vote of confidence from Parliament. Spanish MPs refused to renew his office, which is extending a political crisis that began eight months ago and triggering a countdown of two months of negotiations before new elections are called – for the third time in one year.

Rajoy needed the absolute majority of 176 votes out of 350 to be inaugurated, as he wished, as head of a minority government. He got only 170 votes: 137 from his own party, the People's Party; 32 from the liberal Ciudadanos party; and one from the Canary Islands. This is just a repeat of the scenario that followed the elections on 20 December 2015: with no agreement to form a new government among the four major parties - the two traditional parties (the People's Party (PP) and the Socialist Party (PSOE)), and the two new parties (the radical left, embodied by Podemos and Ciudadanos), new legislative elections had to be organised in June, which also failed to produce a majority. In fact, Spain has not had an actual government since last December, because Rajoy, as acting president, has limited powers. Even though this has not unduly affected the Spanish debt market (Belgium was in the same situation for more than two years), it is clearly not without consequences: continued structural reforms and drafting of the 2017 budget (he still has to present it to the European Commission in mid-October).

According to the Spanish Constitution, the vote of no confidence in late August is forcing the political parties to come up with a government formula within two months. Otherwise, Parliament will be automatically dissolved on 31 October, and new elections will have to be called. The situation is not (yet?) totally blocked, and Rajoy could soon be seen as the 'dissensus' man. The two most likely immediate outcomes are a new leader or a technical government. Otherwise, the hope will be for a real majority to be reached in the upcoming elections. For now, the ECB's QE is doing a good job of protecting the Spanish fixed-income markets.

QUESTION # 6

What would happen if Donald Trump became President of the United States?

The US elections on 8 November will pit Hillary Rodham Clinton (Democrat from New York) against Donald Trump (Republican, New York), Gary Earl Johnson (Libertarian, New Mexico), and Jill Stein (Green Party, Massachusetts). The next president will take office on 20 January 2017.

There are many who already consider that Trump has virtually no chance of being elected, because he will be unable to garner the 270 delegates needed to get into the White House. There are four essential reasons for this:

  • The electoral map strongly favours Clinton.
  • Virtually no minorities (Hispanic or African-American) were spared during Trump's electoral campaign, and his positions on women and LGBTQ have left marks... yet we know how important minority votes are.
  • Geographically, his electoral base is not diverse enough.
  • His positions have been deemed so excessive that even some Republican representatives openly want him to lose.

Currently, the Republicans control the House of Representatives (246 seats out of 435), and the Senate (54 seats out of 100). On 8 November, elections for all of the seats in the House of Representatives and 34 Senate seats will take place, and it is possible that the Democrats will regain control of the Senate. What would happen if Trump became President of the United States?

Internationally and in terms of ideology, Trump has behaved aggressively toward Europe, China, neighbouring Mexico, and Islam. No concessions, lots of bluster, and it's hard to imagine that he would put his various proposals in practice. On this point, he is a huge question mark, unlike Clinton, whose positions are clear and familiar because she has been putting them in practice for the past few years.

Economically, what we see of Trump through his statements is that he embodies Keynesian protectionism. This means:

  • Significant tax cuts (all taxes, individual and corporate alike): reduction in the number of income tax brackets from seven to three, and in the top tax bracket from 39.6% to 25%; a 20% cap on capital gains and dividend taxes; and corporate income taxes down from 35% to 15%.
  • Stimulus on spending, specifically on infrastructure.
  • Reduction in public deficit, not through austerity but due to renewed growth.
  • A more substantial use of customs duties (Trump has spoken of establishing 35% customs duties on Mexican products, 45% on Chinese products, and 10% on the rest of the world) and non-tariff trade barriers. He has also criticised current trade agreements (NAFTA, WTO) and opposed ratifying the Trans-Pacific Partnership (TPP). Finally, he promised the end of “regulatory harassment”.

Electing Hillary Clinton would guarantee the continuation of the current economic policy.

There are three scenarios in play:

  • Scenario #1: Hillary Clinton is elected President: highly likely at this stage;
  • Scenario 2: Donald Trump is elected and puts into practice the policies he announced during his election campaign: this is unlikely at the current time, given the lack of support from members of Congress, including from within his own part y, and the extreme nature of some of Trump’s proposed measures (exorbitant customs tariffs, wall between Mexico and the United States, international relations, particularly with China, etc.). In short, adoption of the proposals announced would only exacerbate the current decline in world trade.
  • Scenario 3: Donald Trump is elected and forced to review his policies. Most likely, only the policies that promote domestic growth, such as tax cuts and the revival of infrastructure spending would actually be implemented. If Trump is elected, this is the most likely scenario.

All in all, in light of the “shock of uncertainty”, voting for Trump is likely to result in a weaker dollar overall, given the Republican candidate’s agenda (Trump rejects the "strong dollar dogma"), depreciation of the renminbi (China would likely face the risk of high customs barriers), fears of a plunge in global growth (to around 2%, or even less), and thus a very negative initial impact on the equity markets. Open economies would be the hardest hit by this event (or by the fears that such an agenda would actually be implemented), emerging economies first, then Europe. The US economy could itself be risking, on the one hand, its growth, and on the other, its debt financing. Furthermore, what about support from foreign investors, with China in the lead, or the impact of a declining dollar? Will carrying US debt to Japan or Europe be enough to protect the greenback? ... All this is assuming that Trump is elected (which we doubt), and that he really wants to roll out everything he seems to be proposing (which we seriously doubt), or that he can do it thanks to support from the next Congress (which we also, just as seriously, doubt). If we position ourselves on the most likely scenario, Trump's measures (pro-growth, pro-US business, a lower dollar and consumption) would be the ones adopted and could be good for the equity markets. A win for Hillary Clinton (the most likely scenario) would bring about much less uncertainty. Her future actions are clearly identified (current economic and foreign policies would be continued) and would not pose any additional threat to the financial markets.

2016-09-asset-allocation-1

 

QUESTION # 7

Will the United Kingdom trigger Article 50 to exit the EU?

"Brexit means Brexit, and we're going to make a success of it". Such was Theresa May's position on the day she was appointed Prime Minister. "There will be […] no second referendum," she added. Since then, while the spirit remains unchanged, the action is still unclear. After the latest government seminar on Brexit (31 August), it is hard to see clearly. Nothing concrete has come from the debates. Britons are concerned about the absence of seasoned negotiators in their midst (for the past 35 years, the European Union has negotiated for its member countries). In addition, they are well aware of a lack of honesty in Brexit leaders, who have underestimated, whitewashed, or hid the real dangers of leaving the Union (which we have summarised in the previous table). The outcome of the referendum now looks more like an impediment to government action than a precondition for regaining the freedom to act. Members of the government have proposed agreeing not to trigger Article 50 (which starts the negotiations to exit the Union) before the German general elections (autumn 2017). It was clear from the referendum's outcome that Article 50 would not be triggered soon, and further proof of that came during the summer. Economically and financially speaking, it is quite difficult to believe that the UK would ultimately emerge as a winner. Politically speaking, can the British government deny a referendum vote? That is the real question. Going by May's recent statements, there is no ambiguity: "There must be no attempts to remain inside the EU, no attempts to re-join it through the back door, and no second referendum. The country voted to leave the European Union, and it is the duty of the Government and of Parliament to make sure we do just that." When? The question remains open and, for now, unanswered.

What can we deduce from this Q&A? Impacts on our asset allocation, in 12 points

  1. Global growth is not picking up, but neither is it weakening, and that is rather good news. The other good news is that it is still driven by domestic demand. Consequently, global trade has lost some of its importance. We continue to bet on global growth of around 3%, US growth around 2% (in line with what preliminary indicators now suggest), and European growth around 1.5% (with intra-zone divergences).
  2. Monetary policies will remain accommodating overall: declining rates in the UK, continued QE in the eurozone and Japan. We are expecting moderate monetary tightening in the US, and the Fed is still far from normalising its interest-rate policy.
  3. Inflation remains under control, including in the US, despite a rise in wages.
  4. Long-term rates are still anchored low, specifically in zones where institutional players like the central banks are buying large amounts of assets (Japan) or well over the amounts of net issues (eurozone).
  5. The search for yield and spread is the driving force in investment.
  6. With low rates and satisfactory growth, the valuation of risky assets can only stay high… and therefore attractive.
  7. The rise in oil prices is generating interest in commodity currencies.
  8. Taking advantage of this are a good number of emerging markets, which have the edge due to attractive valuations and the return of capital flows. They are starting to line up with the hopes identified a few months ago (on this point, see our article from May 2016, "Why emerging markets may be the major story for 2016”).
  9. This does not mean that we must not be selective, quite the contrary: we have long been selective on the emerging markets (where there are still substantial specific risks, Brazil being a recent illustration of this). Same thing in Europe, with the upcoming elections or current political deadlocks. In other words, even though valuations are attractive, many divergences remain in terms of risk and perceived risk.
  10. Spain and Italy are comparable in the eyes of investors. The political deadlock in Spain is at least as much of a risk as the Italian referendum. The current situation argues for a search for yield and spread, and the ECB is, without question, protecting Italian debt and Spanish debt, but recent events will force it to move from one to the other depending on what statements are made and what events unfold. Arbitrage between these two debts will probably drive the European debt markets in the months to come. At present, the Spanish risk may be underestimated, while we consider the Italian risk to be overestimated.
  11. The Q&A above has identified the various risks at this time. Remember, however, because this is crucial at this stage, that certain risks have receded (the Fed's monetary normalisation, China's hard landing, the end of QE in the eurozone); others are stable (Brexit impacts). However, political uncertainties have increased in recent weeks: this is true for Spain, Italy, France, and even the United States.
  12. It still makes sense to hold onto macro-hedging strategies: we had identified several strategies last year, including long positions on US Treasuries, volatility, and gold. We are holding on to them. The political calendars in Italy, Spain, and the US, and discussions on QE programmes in Europe are factors that are likely to add volatility and episodes of stress to risky assets. It will not be a radical reversal, hence the idea of protecting, not fundamentally changing, the portfolios. Keep in mind that electing Donald Trump with the potential / ambition to implement the sometimes extreme policies announced during his campaign would pose an extreme risk to world growth, emerging and European economies (that are open to the outside), the dollar and the equity markets. A real shock of uncertainty.

 

2016-09-asset-allocation-2
2016-09-asset-allocation-3
2016-09-asset-allocation-4

 

The ECB  will  announce before
the end of the year that QE
will go beyond March 2017

 

 

 

QE will not be extended
to equities or bank debts

 

 

 

Our central scenario where the Fed is concerned
is an increase in rates in late 2016, and a further increase in 2017

 

 

 

The likelihood of Matteo Renzi
staying in office (whether
the vote is for or against
reform) is high

 

 

 

 

It is a political roadblock,
but not yet unduly affecting
the debt markets…
thanks to the ECB

 

 

 

 

Is a vote for Trump a vote
for a marked decline in
global growth?
Yes…if he does or can really
do what he is promising

 

 

 

The outcome of the
referendum now looks more
like an impediment
to government action than a
precondition for regaining
the freedom to act

 

 

 

 

Emerging markets are
attractive due to commodity
prices, attractive valuations
and the return of capital flows

 

 

 

 

 

Political uncertainties have
increased in recent weeks:
this is true for Spain, Italy,
France, and even
the United States

 

 

 

 

 

 

 

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Cross Asset of September 2016 in English

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ITHURBIDE Philippe , Senior Economic Advisor
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ASSET ALLOCATION - ECB, Fed, Trump, Renzi, Rajoy, and Brexit. Which are the game changers… if any?
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