Category Archives: Europe

Merkel must spend more

 

merkel1

I seem to have left my purse at home

Yesterday’s ECB press conference was, for the most part, fairly lacklustre. No unexpected measures, Draghi sounding quite bored, forecasts very little changed. Markets had vaguely hoped for at least the promise of more action, but got nothing new. But towards the end there were some interesting comments which, together with the G20 statement last week, underline that the ECB and other central banks are telling governments  – specifically Germany – that there isn’t much more monetary policy can do and it is time for some fiscal action. Draghi’s two comments on this were to state that governments which had scope to do more on fiscal policy should, and he noted that Germany had scope to do more. He also agreed strongly with a questioner who noted the weakness of German wage growth and underlined that higher wage growth in Germany was very much desired. In other words, he told Germany they should be spending more money.

There are a few things the German government can do directly about wage growth. The can pay government employees more, and they can raise the minimum wage, but the majority of wage deals are struck without direct government involvement. As Draghi also noted in answer to another question, Europe is not a planned economy. But without stronger German wage growth, it is very hard to get inflation up in Europe, as German wage costs provide an effective ceiling in many industries to wage costs in the rest of Europe. It was precisely because wage costs elsewhere in the Eurozone rose so much faster than in Germany in the 2000s that the rest of Europe became so uncompetitive, and a lot of this was because German wages barely rose at all. Nominal wage costs in Germany rose less than 1% from 2000 to 2008. That’s in total, not per year.  Given the relative weakness of the rest of the Eurozone, unless Germany can get inflation above the 1.5-2% target, there is no chance that the European average can get up there, and to do that, wage costs have to rise a lot faster. So Draghi is putting pressure on Germany to inflate.

There is plenty the German government can do. German is running a (marginal) budget surplus. The government can borrow at negative rates. It is hard to see the downside to expanding borrowing aggressively and spending on infrastructure, especially since they need to find jobs to give all the extra refugees they are letting in (or wage growth will fall further). It would even provide the ECB with more debt for their QE program. It would not just be a good thing for the Eurozone, it would be a good thing for Germany, where I’m told the roads are in dire need of  attention.

Another way of looking at this is to note that the German current account surplus last year was 8.5% of GDP, and is forecast to be over 9% this year. 9%!!!!!! The UK is worried about it’s deficit of 6% (and rightly so) but the UK problem is at least partly the lack of demand from the Eurozone, and the rest of the Eurozone also struggles because Germany doesn’t import enough. Germany is the main guilty party. It needs to reduce it’s current account surplus by expanding demand. There is no way of doing this by monetary policy any more, as rates are as low as possible already. The government needs to take responsibility by increasing investment.

Why Germany hasn’t gone down this route already is a mystery to me. It seems to have something to do with the fiscal conservatives who believe in balancing your budget without regard to the cycle, the needs of the EU as a whole, or anything that has been written on economics since the 19th century. But it really is time to get real, and Draghi and the G20 are ramping up the pressure on Merkel, Schaeuble and co.  It used to be that Japan was the main guilty party for running massive trade surpluses, then China. Now it’s Germany, and action is overdue.

current-accounts

Source: OECD

From an FX perspective, such actions would be supportive for the EUR in the short term, and some may not like that, but amassing a massive current account surplus is far more damaging in the long term, as it will either prevent a European recovery or cause the EUR will surge higher in the next US downturn as capital outflows dry up.

 

 

 

 

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GBP – History repeating.

It’s all just a little bit of history repeating” The Propellerheads

“We learn from history that we do not learn from history.” Hegel

“The history book on the shelf is always repeating itself” ABBA

Instinctively, I tend to assume the human race has made progress over the last 100 years and our understanding of most things has increased dramatically. Technology has advanced enormously and clearly one thing that has changed in financial markets is the ability to access liquidity in all manner of financial instruments. But has the understanding of what drives financial markets and what is the appropriate valuation for markets improved?  I would like to say yes, but my experience tells me that the answer is no. Technology has vastly increased the amount of information available to market participants, but the understanding of the importance of various different pieces of information seems no better than it was in 1929, 1974, 2000, 2008 or times in between. In fact, the huge increase in the amount of information available may only serve to obfuscate the information of real importance, as markets react to red headlines and systematic asset managers are programmed to react in the same way as in the past or to follow the crowd. An increase in the volume of information only reduces the impact of the information that is of real importance if the market assigns some importance to every piece of information. Or in other words, the more information there is the more possible reasons there are to justify any given market valuation. Thus, the 2000 dotcom bubble found a reason for a wildly out of line valuation, and there were enough greedy investors and trend followers to send equity markets to stratospherically silly levels.

So much for philosophy. What’s the relevance to today’s markets? I wrote recently about the low valuation of European equities (see “A huge opportunity”), and I stick by that view. Some have come back to me worrying about low European growth, Italian banks, Cocos, European immigration, populist movements, but this seems to me to miss the point. There are always risks and concerns, but they have to be evaluated relative to the things that matter for value – in the case of equities this means growth prospects, the initial level of  earnings and dividends, alternative investments (interest rates), and risk premia, which is a bit of a catch all and can be used to justify almost anything, but a sensible view tells me that risks now are less serious than they were at the height of the Greek crisis.

For currencies the metrics are different, and although most of the time the markets are dominated by risk on/risk off trades, it makes little sense to think of currencies moving in this way over the long run. Real currency levels are ultimately anchored to fairly static long run valuation measures, unlike equities which rise over time with nominal growth. Relative growth rates can certainly matter for currencies, not least because they affect relative interest rates, but in the developed world there is actually relatively little long term divergence in growth rates, especially when adjusted for population growth. This isn’t really that surprising, as in the developed world technology and capital is very mobile, and it is hard for one country to show a sustained superior growth performance. Most of the time, better growth is temporary, and comes with a price, usually a bigger current account deficit, as is currently clear in the UK. Changes in the terms of trade – as can be seen with the big move in the oil price – will of course have a long term impact, but I distrust debt fuelled growth (and any growth that is generating an unsustainable current account deficit is debt fuelled from a whole country perspective) as long run reason for currency strength. Sooner or later (admittedly usually later) the positive currency impact of stronger growth and higher rates is reversed either by the need to rein back on growth to control the current account or inflation or the budget, or by others catching up.

What does this have to do with history repeating for GBP? Well it’s a roundabout way of saying that the strong pound, the growing UK current account deficit (and indeed twin UK deficits) are a repeat of a long history of similar episodes in post war UK economic history. The strength of the pound won’t last and we are headed for either a slow or a fast decline in the pound, depending on whether the UK stays in the EU (staying will hold GBP up) and whether the world economy picks up (if it does the decline in GBP will be slower). But the period of UK and GBP outperformance is hitting traditional current account buffers. Sure, UK won’t have to go cap in hand to the IMF this time as in 1976, and a fading of Brexit fears may trigger a GBP rally of sorts. But whatever the politicians agree, the risk of a vote to leave will remain, and more importantly, the underlying economics doesn’t justify a stronger pound, or even as strong a pound as we have now in the longer run. With even McCafferty accepting that UK rates aren’t going up, EUR/GBP is a buy on the dip, even if the ECB cut again as is widely expected and add to QE. Look for 0.85 this year in EUR/GBP, possibly 0.95 if things go badly on Brexit.

 

EUR/GBP rally – if not now, when?

After flirting with the 0.75 area for a few days, EUR/GBP has pushed through on this morning’s weak industrial production data and has potential to start making real ground to the upside. Technically, there are some reasons for caution. Although last week saw a strong weekly close at the highest level for a year, we have had seven consecutive up weeks and the weekly channel top at 0.7525 hasn’t broken convincingly. But, if not now, when?

GBP has been overvalued for a long time, most particularly against the EUR, it’s largest trading partner. It is also a lot more overvalued than it looks, for two reasons. Firstly, because UK inflation has been much higher than inflation in other major economies since the financial crisis. While inflation has recently been subdued, CPI in the UK has risen 10% more than CPI in the US or the Eurozone since 2008. So 0.75 now is equivalent to 0.68 in 2008 in real terms. Secondly, the UK is running a current account deficit of 6% of GDP – the largest in the developed world – while the Eurozone is running a surplus of 3% of GDP. While the UK deficit has come about mainly because of declining UK investment income rather than a rising trade deficit, it won’t be closed by improved export performance at this level of GBP. Historically, current account positions DO matter for valuation over the long run, and the widening of the UK deficit suggests to us that long run fair value for EUR/GBP is more like 0.85 or 0.90 than 0.75.

But this has been the case for some time Why should GBP suffer now?

  1. The long awaited UK rate hike still seems to be disappearing into the distance as wage growth stalls, so those looking to buy GBP on yield spread grounds have little support in the short run.
  2. GBP has already fallen a long way against the USD, and while it may fall further, yield spreads between the US and Europe have also stalled or narrowed of late as US data has slightly disappointed since the Fed rate hike, so there seems limited downside for EUR/USD from here in the short run, suggesting at least as much GBP downside potential against the EUR
  3. The EU referendum question. The possibility of Brexit is clearly negative for GBP and while I personally think there will be a strong majority in favour of staying in the EU, the foreign investment that the UK needs to funds its current account deficit is unlikely to be too enthusiastic while the question is in the air.
  4. Policy wise, there is nothing the government or the Bank of England would like more than a weaker pound. They will never try to force it, but I wouldn’t be surprised to see a little verbal encouragement of GBP weakness.
  5. A weak oil price is more supportive for the Eurozone than the UK, given the Eurozone is a much bigger net oil importer.

By the time we get to the referendum (maybe June) I expect we will already have seen the big decline in GBP, and we may see a recovery after the referendum if, as I expect, we get a vote to stay in. The recovery may start before the referendum if it looks like the “remain” campaign is going to win easily. There is no time like the present for the GBP bears to get the ball rolling.

 

CHF and GBP vulnerable

So we start the new Year with another bout of risk aversion, rooted it seems mostly in China, though the US numbers have also not been great. But today’s European PMI data was fine, and Sweden’s was certainly good. The market is a bit overobsessed with China in my view, especially since we can’t really trust the data. In any case, if China is a problem for growth in the developed world it should be showing up in domestic  data. So I like buying the European equity indices on this dip, and don’t see general risk aversion lasting.

From an FX perspective, the implications of risk aversion are less clear than they used to be. Yes the JPY has strengthened, but the CHF is still weak, especially against the EUR, and this may be a signal that the CHF is going to suffer this year. EUR/CHF has had every chance to go back below 1.07 but hasn’t managed it, and has surged lower over the New Year. With heavily negative yields and still very expensive valuation, there is little to recommend it except in extreme risk aversion when money may once again stop flowing out of CHF. For now, the CHF should be a core short.

The other currency which looks likely to be something of a focus early this year is GBP. Some are noting that the GBP sell off looks a bit overdone because yield spreads don’t suggest it should be this low. But even if you disregard all the concerns related to the potential EU referendum, the case for buying GBP on the basis of yield spreads is pretty weak. The big UK current account deficit and the relatively high UK inflation since 2008 (about 10% more than the US or Eurozone) mean GBP already looks very expensive. In fact, it’s just as expensive as the CHF in my models. So expect GBP to stay under pressure at least until the data shows a case for an early rate hike of the EU worries fade. I doubt either of these will happen before February at the earliest.