Reflation Meme is Tested

As the first quarter draws to a close, the divergence that has been central to our understanding of the investment climate is being challenged.  Continued above trend growth, and inflation that has jumped to 2% in the eurozone, have spurred more talk of an exit from the extraordinary monetary policy, which could include a rate hike while assets are still being purchased and the European Central Bank’s balance sheet is still expanding. 

With less fanfare, the Bank of Japan has shifted its policy to targeting both overnight money and 10-year bond yields, allowing for a slower expansion of its balance sheet.  It also made a marginal reduction in the bank balances for which the negative deposit rate applies. One member of the Bank of England’s Monetary Policy Committee voted to hike rates immediately, and although she did not sway her colleagues, the other members did agree that tolerance for above target inflation with a resilient economy would not be tolerated for long.  The People’s Bank of China surprised many with a hike in some operational rates within hours of the Federal Reserve’s second hike in four months. 

The Federal Reserve’s rate hike was not accompanied by any signal that the increased confidence officials have indicated about the resilience of the US economy and that inflation will continue to move to the target will translate into a faster pace of normalization. In fact, the FOMC reaffirmed that the majority of officials anticipate two hikes in the remainder of 2017 and three hikes in 2018. 

Also, the US economy appears to have begun the year on particularly weak footing. In the 2010-2016 period, US growth has typically underperformed.  The average annualized pace that the world’s largest economy expanded in Q1 has been nearly 1.1%.  That is less than half of the 2.5% average annualized growth in the rest of the year.  The pattern seems set to continue, or at least Q1 growth is likely tracking around the average pace. 

We anticipate that the reflation story will look much different three months from now.  Survey data, such as purchasing managers and consumer confidence, appears to be running ahead of actual economic performance.  Credit expansion in the euro area remains paltry.  The reduction of the current account surplus in January, the most recent data available, warns of the risk of slower growth. 

The rise in headline inflation remains mostly the result of higher energy prices and weather-related seasonal food prices.  Core inflation has been extremely stable, a little above the 0.6% trough at 0.9%.  The calls playing up the possibility of a deposit rate hike (from the current negative 40 bp) appear to have come from those parties that have not been particularly supportive of the ECB’s monetary policy, such as in Germany and Austria. 

Contrary to the oft-repeated claim, Germany does not dictate the European monetary policy, even though it is the single largest member.  The German central bank and the finance ministry leave little doubt that they would prefer a less accommodative monetary policy stance.  The central bank even participated in a court case seeking to overturn the ECB’s stance.  ECB President Draghi may be right that Germany’ ordo-liberalism is part of the central bank’s DNA, but that does not mean its interests determine policy. 

The ECB’s exit strategy has not been mapped out.  The March ECB press conference and updated staff forecasts suggest that should the penalty rate on deposits be reduced, it will not be a Q2 decision.  Moreover, a reduced penalty would not necessarily impact the more important refi rate. 

In the UK, while inflation may not peak until the end of Q2 or early Q3, the real economy is set to slow, and this will likely prove sufficient to keep the BOE on hold.  The lone dissent from steady policy in March, Kristin Forbes, will step down at the end of her three-year term in June. Poor wage growth suggests a headwind on demand and a check on price pressures going forward.   

While the BOJ has adjusted the implementation of its unorthodox monetary policy, price pressures remain practically non-existent in Japan, and even with fiscal support, the economy languishes. Wage growth has been miserly and household demand poor.  Domestic returns are too low for savers, and although the Japanese were net sellers of foreign bonds over the past quarter, we expect that they will return in Q2. 

We suspect the possibility of a June US rate hike is higher than the one-in-three chance the market currently assesses.  We expect the US economy to recover from the soft patch in Q1, led by stronger consumption and supported by continued job and wage growth.  The recovery in oil prices and the deployment of more rigs may underpin manufacturing and business investment.  The Federal Reserve is still likely to hike its Fed Funds target range at least a couple more times before other major central banks hike.  Despite the wobble, we do not think peak divergence has passed.

France is the Next Battleground for Populism-Nationalism

The rise of anti-EU and anti-immigration parties in Europe, the UK referendum to leave the EU, and the election of Donald Trump as the 45th US President are widely thought as evidence of a populist-nationalist wave sweeping over the world.  It is seen as an anti-establishment push in the wake of the financial crisis.  Unemployment remains stubbornly high in parts of Europe, while low unemployment in the US, UK, Japan, and Germany has not been accompanied by strong wage growth.

The Dutch turned back their populist challenge, though the Freedom Party increased the number of parliament seats it has and, in the fragmented system, is the second largest.  Even though Prime Minister Rutte’s PVA came in first, it still lost seats, and its coalition partners, especially Labor, were soundly trounced.

The price of turning back the populist-nationalist challenge may be a shift of the political discourse to the right.  The Dutch government’s aggressiveness toward Turkish diplomats would have been less likely previously.  European center-right parties, for the most part, can emphasize an anti-immigration tone, law and order agenda, and little patience with Islam, but they will not, or at least, have not compromised on EMU or EU membership.  Italy’s Berlusconi is an exception to this generalization that proves the rule.

Even in the US, Trump’s fiscal plans for the remainder of the year show little evidence of populism (except some funds earmarked for the wall on the Mexican border).  It was a conservative’s budget with sharp cuts in discretionary spending for a range of soft power programs (e.g., cultural spending, foreign assistance, Amtrak,  Department of Transportation) to primarily fund more military spending on top of what was already projected.

The populist-nationalist victories in the US and UK seem peculiar to their two-party systems. In both cases, the populist-nationalist party did not win.  What happened was that the center-right party adopted at least part of the populist-nationalist agenda.  This will be more difficult in the multiparty political systems in Europe, where the center-right parties ran against the nation-populists.  There is a political tradition of the main two parties cooperating to improve the chances of defeating the National Front.

In France, the National Front’s Marine Le Pen continues to hold on to first place in the polls.  A scandal over hiring family members has weakened the center-right's candidate Fillon.  The former Socialist Macron has moved into second place.  Either of the two would beat Le Pen in the second round.  Parliamentary elections are in June, allowing a new government to form in Q3.

In Germany, the main development has been the reinvigorated Social Democratic Party under former EU Parliament Speaker Martin Schulz. The polls suggest nearly six months before the electionthat it is a dead heat between the SPD and Merkel’s CDU.

The defeat of populism-nationalism in the polls does not mean that issues that it raises have gone away or been resolved.  National identities have become more salient.  There are many forces at work: immigration, the financial crisis, and changing economic competitiveness.  The disparity of wealth and income have increased. An increasing number of young people in high income countries are unlikely to live as well as their parents.  Debt levels (public and private) continue to rise, and this can also be seen as a generational wealth transfer.  Class mobility has become more rigid.

The national elites have an opportunity to respond to the challenge, but it may be like Draghi calling for structural reforms:  a good idea but poor execution.  We have found many investors and observers can follow us on this year’s elections outcomes in Europe.  However, many think that next year’s Italian election is where the real challenge lies.  It is not clear how badly split the center-left PD party is, or whether Five-Star Movement’s difficulty in governing Rome will weaken it in the national contest.

Meanwhile, formal negotiations between the UK and the EU will begin in earnest in the coming months.  In the nine months since the referendum, the initiative was the UK’s.  It chose how and when to respond to what was a non-binding referendum.  However, once Article 50 of the Lisbon Treaty is invoked, the initiative and balance of power shifts to the EU.  Once the negotiations are underway, the full extent of the interconnectedness and costs of extraction will be clearer.  The more difficult or strained the negotiations, the worse sterling may fare, with an important caveat that speculative participants have amassed a record short sterling position in the futures market as the first quarter draws to a close.

Trump’s Agenda and the Federal Reserve

Since before the financial crisis, some observers argued that there was a hegemonic stability crisis.  The US, they argued, was too weak to enforce a coherent set of international rules or engagement as it once did.  Other countries lacked the institutional capability to do so.  The head of the Eurasia Group penned a book in 2012 that captured this spirit called, “Every Nation for Itself: What Happens When No One Leads the World.”

Yet Trump’s presidency is a notable break from the past.  It is perhaps the first illiberal US administration since the 1930s.  It has upended many key elements of the US grand strategy, like its commitment to a multilateral rule-based trading regime and that an integrated Europe was in the US interest.  The transactional approach to America’s place in the world and the threat not to defend NATO members who do not spend the agreed 2% of GDP on defense belies the two or three generations of leaders who recognized that peace and prosperity in the US required peace and prosperity in Europe.

At the same time, it is important for investors to recognize that there is a range of opinions among senior officials in Trump’s administration.  There are some who do embrace the liberal global order but also want to project US power and interests more forcefully.  It is not clear which faction will carry the day on any one issue.  There are others who would prefer to return to the America First of Warren Harding in the 1920s, which replaced Wilson after the rejection of the League of Nations.  The era is often referred to as isolationist, and Trump is often accused of being an isolationist.

Trump rightfully rejected the label.  It looks as if Treasury Secretary Mnuchin was handcuffed by this at the G20 meeting, where the reference to resisting protectionism was dropped.  Apparently, he did not have a mandate to embrace proposals about fair trade either.

That may be under the Commerce Department’s portfolio.  Investors and foreign officials need to be particularly sensitive to the differences between formal and informal power relationships. The optimistic case is that on trade, foreign exchange, and other international matters, the Trump administration respects current insitutions and agreements, but seeks stronger enforcement of existing rules.

President Trump’s proposed defense department budget (the increase alone is nearly the UK’s annual defense budget), the escalation of tensions with North Korea, and the increased activity in Yemen and Afghanistan is not an isolationist agenda.  It is unilateralist, as in not wanting the freedom to pursue national interest to be limited by a multilateral entity. 

The US Treasury is expected to issue its semiannual review of the international economy and foreign exchange practices in April.  By the current criteria, China is unlikely to be cited as a currency manipulator, though with a new Treasury team being formed, the criteria could be modified in the future.  We suspect at this particular moment, if China were to stop intervening entirely and finish opening its capital account, the yuan could fall sharply and interest rates would rise, ultimately weakening an important engine of world growth. 

President Trump’s first priority has been to replace Obamacare.  Replacing Obamacare and cutting the associated taxes is a cornerstone to broader tax reform.  The bill that is emerging from the House of Representatives does not look likely to win the necessary Senate approval.  This will force the measure into reconcilliation, where a simple majority is sufficient for passage.  Although polls point to low public support for Trump, he continues to enjoy strong support among Republicans.  This may keep members of the House of Representatives, who all face elections next year, squarely behind the President.  The Senate is a different story and is where many of Trump’s Republican critics reside.

Mnuchin would like a tax reform to be passed before the summer recess in August.  Tax reform requires not only a resolution of health care but also important decisions to be made on trade.  The border adjustment was supposed to raise a trillion dollar in revenues.  There are many moving parts of the tax reform, including the tax break for the repatriation of earnings retained offshore, abolishing the tax break for corporate debt servcing, and immediately being able to depreciate capital expenditure.  There is great risk that tax reform is delayed, and the infrastructure initiative is pushed into next year.

Lastly, there are two elements about the Federal Reserve that will shape the investment climate.  First, is Fed policy.  The May FOMC meeting is not live in the sense that there is practically speaking no chance of a hike.  Whatever gradual means it does not mean back-to-back hikes.  We suspect that at a one-in-three chance, the market is underestimating the likelihood of a June hike.  We would put the odds at a bit better than 50-50.

We expect while job growth may slow, the slack in the labor market will continue to be absorbed.  Hourly earnings growth will likely stay firm, just above the pace of headline CPI.  Soft consumption in Q1 will return to the stronger underlying trend, helped perhaps by the late payment of tax refunds.  We expect the global climate to also be conducive for the Fed to move, barring an escalation of conflict in Asia or a de-stabilizing populist-nationalist victory in France.

The second element is that there will be three vacancies on the Federal Reserve’s seven-member Board of Governors beginning in April when Governor Tarullo steps down.  President Trump’s Supreme Court nominee will likely easily be confirmed and then attention will shift to the Federal Reserve.  It is possible that one of Trump’s appointments later becomes the Chair when Yellen’s term is up next year.  Leaving aside the implications for other parts of Trump’s economic agenda, we expect the President’s nominees to be represent hard money and be aligned more with the hawkish regional presidents.