It is premature to abandon global reflation theme

by: Gavyn Davies

The global reflation regime that has been dominant in the financial markets for much of the past 12 months has paused in recent weeks. Many commentators, including James Macintosh at the Wall Street Journal and the FT’s Gillian Tett, have suggested that this pause in the markets is giving ominous signals about the health of global economic activity. Concerns have been expressed about the strength of official US GDP data in 2017 Q1, and there have been unexpectedly low readings for core inflation in several economies.

This shift in mood is probably too pessimistic. The change in market behaviour has so far been small, relative to the large rise in equities and the decline in bond prices seen since world activity bottomed in February 2016. Furthermore, while there has been a modest slowdown in US activity indicators since March, the growth rate remains well above trend, and the official GDP numbers are likely to be much stronger in 2017 Q2 and Q3.

However, there are legitimate concerns about the ability of the Trump administration to deliver the large fiscal stimulus that had been expected. These concerns need to be addressed in the announcements on tax policy that are expected imminently.

What, exactly, is the “reflation” trade? Since the China currency squall blew over a year ago, indicators of global growth have picked up sharply, and fears of deflation in the Eurozone and Japan have evaporated.

These developments were taken as evidence that an expansionary demand shock was driving the global economy towards recovery. First, in February 2016, equities embarked on a new leg of their long-term bull market, defying forecasts of a global recession. Then, in mid 2016, global bonds entered a bear tack as deflation risks were priced out of markets. Finally, the reflation trade received a large further boost in November, when it seemed clear that the Trump administration intended to implement a huge cut in corporate and household tax rates, Congress permitting.

This is how US equities and bonds have responded to changing perceptions of reflation since the start of last year:

In the last few weeks, the theme has begun to fade in the asset markets. The graph below shows 30-day returns from US bonds and equities. These returns have continued to move in opposite directions, which is what would be expected if the global economy is being driven by shocks to aggregate demand. (Higher demand growth should raise profit expectations and thus help equities, but also raise inflation and interest rates, damaging bonds.)

But in this latest period, it seems that demand expectations have been marked lower, raising bond prices substantially, and reducing equity prices somewhat less. It is possible that there has also been a rise in risk aversion in response to today’s French election, North Korean tensions, and the US military raid in Syria. The increase in geopolitical risk perhaps explains why bonds seems to have been affected more than equities:

Apart from geopolitics, several economic developments have come along to cause investors to have doubts about the “reflationary” theme.

First, markets seem to have lost confidence that the US economy is accelerating, let alone showing signs of achieving “escape velocity”. These doubts are probably misplaced.

Admittedly, economic data surprises have been less favorable than they were in 2017 Q1, and there has been little sign that hard data are breaking upwards. However, the Fulcrum nowcasts suggest that US activity has been growing at 3.9 per cent in April, only slightly lower than the 4.5 per cent rates seen in the previous couple of months. Goldman Sachs’ current activity indicators, which track real time growth data using a slightly different methodology, show a similar pattern: growth is down a bit, but it remains very firm.

The well known seasonal adjustment bias in US GDP data may result in the first official estimate Q1 growth rate coming in at only 1.0-1.5 per cent, but a more realistic estimate of the state of the economy is the 2.7 per cent growth rate shown in the New York Fed’s latest nowcast for the quarter. As the seasonal bias is ironed out in Q2 and Q3, it would not be very surprising if the official GDP data jump to above 3 per cent, ending the idea that the US economy is in the doldrums. Meanwhile, the rest of the world economy is now in the midst of an unambiguous and synchronised acceleration, as the IMF cautiously acknowledged this week.

Second, there is the issue of global inflation. Some months ago, I argued that inflation in the advanced economies would move sideways this year, having risen last year as it returned to normal after the commodity price shocks of 2014-16. Global “reflation” would still involve faster growth in nominal GDP, but this would come entirely from the real output component, and not from any further rise in inflation. That assessment seemed to be on course until last month.

However, it did not allow room for any decline in core inflation as the year progressed. Oil and metals prices have dropped in the spring, and that will probably bring headline inflation down for a while. But there would be real concern if core inflation also starts to drop, which is why the the apparently weak inflation data released last week in the US and the Eurozone has come as a nasty surprise.

Fortunately, the official data releases in March have probably been distorted downwards by special factors, including the timing of Easter. The graph below shows the latest Fulcrum estimates of trend inflation in the two regions, adjusted for all seasonal factors and smoothed using the Stock and Watson method. In our view, this is the best method available for assessing underlying inflation in real time. It is clear that there has been little change in core inflation rates in March, and that the official data in the US have been heavily distorted downwards:

We therefore conclude that the incoming economic data have not changed enough in the past couple of months to justify the shift in market behaviour towards what is now known as “reflation off”. (See the FT’s John Authers for more on this view.)

However, the theme will face more severe tests from geopolitics, notably the French Presidential election and Steven Mnuchin’s US tax plans, to be announced next week. Disappointment on either front could upset the apple cart.

Declaration of the Rights of France

Europe’s future hangs on the nation-state’s ability to respond to the concerns of individuals.

By Jacob L. Shapiro

The first round of voting in France’s presidential election is over, and pre-election polls seem to have predicted the correct outcome. As of this writing, exit polls show Emmanuel Macron won 23.7 percent of the vote, while Marine Le Pen received 21.7 percent. The two candidates will now go head-to-head in a May 7 runoff. This does not mean Le Pen will be elected president, as polls show her at a substantial disadvantage to Macron in the runoff. It also does not mean that Le Pen will be able to enact any of her policies should she be elected unless a sea change occurs in June’s legislative elections. Le Pen getting this far is not unprecedented – her father, Jean-Marie Le Pen, got this far in 2002 before losing in a landslide to Jacques Chirac in the second round.

Even so, Marine Le Pen is not her father, and the stakes in 2017 are much higher than they were in 2002. The polls were right for the first round, but that does not guarantee they will be right in the second. This is partly because Macron is a political neophyte – no one knows quite what he stands for. Meanwhile, Le Pen has worked hard to purge the party of her father’s legacy, which included denying the Holocaust and other offensive positions. The memory of such things does not fade quickly, but Le Pen has made considerable progress in normalizing the National Front in French politics. The National Front is the rare populist-nationalist party that has softened its positions before getting voted into office. Le Pen has put herself in a position to contend for the French presidency, so it is necessary to think about what that means and whether it is important.

Supporters of National Front leader Marine Le Pen cheer at l'Espace François Mitterrand on April 23, 2017 in Hénin-Beaumont, France. According to projected results, “En Marche” candidate Emmanuel Macron received the most votes in Sunday’s presidential election with Le Pen in second, meaning the two will compete in a runoff on May 7. Jeff J Mitchell/Getty Images

This is more difficult to do than it sounds because the media’s narrative about Le Pen’s rise has been hysterical. The next two weeks will feature more of the same: articles decrying the potential end of Western civilization, the rise of fascism, and the potential unleashing of the horrors of Europe’s past across the Continent once more. Many who never much cared about France will spontaneously generate opinions about how the West’s hopes now rest on Macron’s shoulders. If Le Pen wins, it will be the French Devolution. If she loses, complacency will set in, and Macron the empty suit will take up residence at the Palais de l’Élysée. He will continue status quo policies that in five years will bring us right back to where we started – or perhaps worse.

The key questions no one is asking are: Why did Le Pen oversee the expulsion of her father from the National Front, and why has she worked so hard to exorcise the party’s most radical positions? Stated differently, does Le Pen control her constituents, or do her constituents control her? The answer to this question is important because it is the difference between the National Front being a reanimation of the worst of 20th century European history and a 21st century political party attempting to respond to economic, political and security challenges while still operating within the framework of liberal democratic norms. If the masses control Le Pen, we’re back in the 20th century. If Le Pen controls the masses, we’re still in our own century.

The horrors of Hitler’s Nazi Germany and Stalin’s Soviet Union boggle the mind, and ascribing either of those atrocities to a single man makes them easier to process. If we can process tyranny as that of an evil and unhinged individual, then society escapes blame. But as is often the case in geopolitics, the individual is less important than he seems. The totalitarian rulers who rose in 20th century Europe depended on the masses as much as the masses depended on them. A totalitarian movement relies on the breakdown of all prior social ties. Unflinching loyalty to a mystical regurgitation of “the nation” becomes paramount. Europe is not afraid of a right-wing, populist and nationalist politician. Europe is afraid that the masses will become so disillusioned that not even Le Pen will satisfy them. Whether Le Pen is leading her constituents or they are leading her may seem like an abstract question, but it is of the highest practical importance in determining if this is politics as usual or the beginning of something more sinister.

Le Pen represents two major constituencies in France. The first is her fathers’ supporters, who had no problem with his denial of the Holocaust and are displeased that she would moderate the National Front’s platform. There is a tendency to think of France as liberalism’s vanguard and the birthplace of “liberté, égalité, fraternité.” But the French Revolution was followed by the “Reign of Terror” and Napoleon’s empire. The Dreyfus Affair in the 1890s and the anti-Semitism it shone a light on was so virulent that it drove a secular and assimilated Jew named Theodor Herzl to the conclusion that Jews would never be accepted as equal members in the new European nation-states. Free France fought the Nazis, but Vichy France was a government of collaborators. Beneath and between the French republics are dangerous ideological currents that failed to come to power in the 20th century but are no less real for not having achieved their ultimate goals.

The second major constituency Le Pen has come to represent has nothing to do with this kind of thinking and is offended by it. This constituency has two key concerns: the economy and Muslim immigration, in that order. The latest unemployment figures in France stand at 10 percent. Those rates are worse in the south and as high as 25 percent for people under 24. GDP growth is stagnant.

Debt is almost 100 percent of GDP. Southern France has always been the National Front’s bastion of support, but parts of the northeast are now backing the party, too. This region historically has been one of the main centers of French industrial production. Workers are losing jobs in this part of France, while across the border in Germany, unemployment is at an all-time low. Successive mainstream political leaders from across the spectrum have failed to improve the French economy despite numerous promises. Le Pen says that the issue is the European Union and that she has a plan. Many are fed up enough to see if she can deliver.

(click to enlarge)

The second issue for these voters is immigration, and by extension, radical Islam. Three days before the election, on April 20, a shooting happened on the Champs-Élysées that was claimed by the Islamic State. Paris and Nice suffered horrific terrorist attacks perpetrated by radical Islamists in 2015 and 2016, respectively. Le Pen’s platform addresses this in two ways. First, she wants to strengthen the rule of law. She plans to do this by hiring more police, building more jails, and shutting down mosques with ties to radical Islam. Second, she wants to crack down on illegal immigration. This means curbing asylum requests and introducing more stringent naturalization requirements. Le Pen also plans to limit legal migration to 10,000 people per year. One may disagree with Le Pen’s approach, but not with the fact that a problem exists and previous French governments have failed to address it.

Le Pen has earned the media’s ire for her desire to take France out of the EU and to protect not just the country but also what it means to be French. But Le Pen, at least in what she has said and done so far, is not her father, and the sins of the father should not be needlessly visited upon the child. What Le Pen is saying is not unreasonable. She is responding to a contradiction that is embedded in the core of both France and the entire liberal democratic project. It is a contradiction that most of the European political class has felt content to ignore, even as the European economy has been crippled and countries have become targets of radical Islamist terrorism.

Article 1 of the Declaration of the Rights of Man says, “Men are born and remain free and equal in rights.” Article 3 says, “The principle of all sovereignty resides essentially in the nation.” This is a contradiction. Article 1 is universalist; it does not say “French men are born and remain free and equal in rights.” It says all individuals enjoy these unalienable rights. But on the same page, Article 3 becomes pragmatic, attempting to ensure these rights are protected.

Without enforcement, rights are abstractions. The individual may have rights, but we do not live in a world of individuals. We live in a world of political communities. The French nation is Le Pen’s political community, and her policy is to defend it. For her detractors, Le Pen’s great crime is that she does not consider it France’s responsibility to ensure the unalienable rights of all men. For her supporters, she is the defender of the unalienable rights of French men, and to ask France to do more is to ask the impossible.

Europe has been struggling with this issue for over a century. It fought World War I and World War II over this problem and still could not find a solution. After World War I, new nation-states emerged, but so did millions of stateless people who had no nation-state because of the way borders were drawn or because of overall diversity. This had tragic results. The end of World War II brought international institutions that promised to secure peace and to stand up for the rights of individuals and for nation-states. Those institutions have failed to secure peace and to stand up for the rights of individuals because they have no way to defend or enforce those rights. The civil war in Syria, the genocides in Bosnia and Rwanda, Russia’s invasion of Georgia and the frozen conflict in Ukraine are all examples of what happens to individuals without nation-states strong enough to defend their own. Couple this with the European Union’s inability to respond to the 2008 financial crisis and the economic problems affecting not just France but also the entire European continent, and you arrive at the current level of political disenchantment throughout much of Europe.

That disenchantment is spreading. Scotland and Catalonia say they will hold independence referendums. Two regions in northern Italy, Lombardy and Veneto, said on April 21 they will hold autonomy referendums. The Balkans are still not settled, and even in Germany, there are whispers that perhaps Bavaria would be better off going it alone. These are all symptoms of this basic contradiction at the heart of the liberal democratic order. All men have rights, but the nation is the protector of those rights. Without a nation, you can insist on rights until you are blue in the face, but no one will respect them. Le Pen sees this problem and says that France has let the strength of its nation atrophy to the point where it cannot control its economy and its security.

This is the source of her popularity in France and the reason the National Front has succeeded in growing beyond the narrow and radical base of her father. Le Pen may end up losing the election. But the issues to which she speaks will not disappear, and at some point, either she, or someone like her, will come to power. The question, then, will not be whether Le Pen or whoever succeeds her is a neo-fascist demagogue. The question will be whether France’s government can succeed where those before have failed by creating a sense that it is responding to the economic and social problems that have brought the country to this point.

There is a dark side to France, as there is a dark side to all countries. But Le Pen is not a slave of the masses. She is a political pragmatist who is holding back something far worse, and she knows what the “something far worse” is because she tried to exorcise it from her own party last year. This election is important because of what it indicates about the future of Europe. That future hangs on the nation-state’s ability to respond to the concerns of individuals. We have seen what happens when it can’t, and the result was far more disruptive than a French nationalist becoming the newest president of the Fifth Republic.

Happy returns

America’s big banks have an encouraging first quarter

Uncertainty over the future of regulation still clouds the Outlook

WHAT a difference a year makes. When America’s big banks reported first-quarter earnings for 2016, the mood was glum. The Federal Reserve was proving tardier than hoped in raising interest rates, which held down lending margins. Jitters about the world economy meant rotten results for investment-banking units, in what is usually their best season of the year. Regulators added to the misery: last April the Fed rejected the “living wills”—plans for liquidating lenders that get into trouble—of five of the six largest banks.

This spring bankers are happier. Business perked up last year after that dismal start. Donald Trump’s election in November, accompanied by promises to ginger up the American economy, cut corporate taxes and roll back regulation of finance, gave banks’ shares a lift (see chart).

The Fed raised rates in December and again in March and is likely to keep increasing them.

And 2017’s first-quarter results have, mostly, seen an improvement—though the cheer was not evenly shared.
“Wall Street activities have performed better than Main Street ones,” says Mike Mayo, an independent bank analyst. Revenues from capital-market businesses at the five biggest Wall Street firms, Mr Mayo calculates, rose by an average of one-fifth in the first quarter of the year, compared with a year earlier.

Underwriting and fixed-income trading were buoyant; equity trading and advice were flattish. Morgan Stanley, the last big bank to report, was arguably the star turn. On April 19th it said its fixed-income revenues had almost doubled, to $1.7bn, apparently vindicating a thorough overhaul of the division early last year. The firm’s net income rose by 70%, to $1.9bn.

The previous day Goldman Sachs had disappointed analysts, although its net income was twice as high as a year before. Its fixed-income, currency and commodities revenues were flat, also at $1.7bn. It also lagged behind the field in equities. Volatility in the foreign-exchange, crude-oil and equity markets was subdued: hedge funds (on which Goldman’s trading business is more reliant than its rivals) were consequently less active. Even so, admitted Goldman’s Martin Chavez, “we didn’t navigate the market well”.

Business on Main Street was more sluggish. Bank loans grew in the first quarter by just 0.7% at an annualised rate, according to the Fed, the slowest for almost six years. Commercial and industrial lending shrank for the first time since late 2010. Residential-mortgage lending also declined. But widening interest margins helped some banks, as loan rates went up faster than funding costs: Bank of America’s spread rose by 18 basis points from the previous quarter and JPMorgan Chase’s by ten.

In such a quarter Wells Fargo, the least dependent of the big six on investment banking, was perhaps the least likely to shine. Its net income, at $5.5bn, was virtually unchanged from a year before and a shade up from the fourth quarter. A quarterly increase in commercial lending was outweighed by a decline in consumer loans, mainly mortgages.

But Wells has other worries. It is still recovering from last September’s revelation that it had opened more than 2m ghost accounts. It hopes that a scathing report this month by outside consultants, the dismissal of several executives and the clawing back from them of $180m in pay and shares will help it to recover customers’ trust. It has some way to go: the number of current (checking) accounts opened in March was up by 7% from February, but 35% lower than a year before. Institutional Shareholder Services, a firm which advises investors, has recommended voting to replace most of Wells’s board at the annual meeting on April 25th.

Wells’s woes notwithstanding, banks ought to be able to look ahead in good heart. Rates are likely to rise further, America’s economy is in good shape and Wall Street firms stand to gain as Europe picks up too. But a cheerful year is by no means assured. Mr Trump’s tax-cutting plans are not yet formed and the future of bank regulation is still unclear. Hence the stalling, in recent weeks, of the rally in banks’ shares.

Bankers have argued that it is high time red tape was cut: lending, they say, is being held back.

Mr Trump is due to appoint several regulators who may lift their burden. But his chief economic adviser, Gary Cohn, formerly at Goldman Sachs, has mused vaguely about a “21st-century version” of the Glass-Steagall act, the Depression-era law that separated commercial and investment banking, repealed only in 1999. With no details, bank bosses were coy in earnings calls with analysts, but “Glass” and “Steagall” are not soothing words.

Why the EU Was Doomed From the Start

by Jeff Thomas

Back in the ’90s, when the EU had ceased to be a mere trade agreement and had become a full-blown oligarchy that would eventually gobble up most of Western and Eastern Europe, my belief was that it had not only been a doomed concept, it had additionally been rushed into being far too quickly. Although, at that time, the governments of Europe were gleefully joining up, I said, “I give it twenty years, tops.”

It was an offhanded remark and, in truth, I was throwing a dart at a board regarding the time period, but twenty years did seem about right to me. And this shouldn’t have been a difficult prophecy. There were three major reasons for its validity.

“Good Fences Make Good Neighbors”

First off, the countries of Europe had perennially been at war with each other since long before gunpowder was invented. Europe is basically tribal and there is simply no way that the mindsets and objectives of, say, the British are going to be the same as, say, the French. If under the EU diktat, British fishermen were then told that they could no longer fish their own waters because Brussels had decided to give British territorial waters to the French so that they could fish, there would be greater cause for enmity between countries than ever before in history. (The quote above from Robert Frost was meant to pertain to individual property owners, but it applies equally to modern-day tribes.)

Sudden Change Breeds Resentment

Second, the rulings from Brussels came in a torrent after its formation. Nearly every country in Europe was shoehorned into fitting in with union objectives. As a result, whilst some countries gained some advantages, all countries lost the basic freedom that comes with self-determination.

Those who objected were threatened that they’d better behave. Those who suggested departing from the union were further threatened that they’d be shut out of EU trade and destroyed economically.

Most people behave like sheep in most situations. That’s a basic trait of mankind, in any culture, in any age. However, sudden change (in either events or public opinion) often sparks revolt. Certainly King George of Britain discovered this when he chose to make up for a wartime monetary shortfall by imposing a stamp tax on his colonies in America. A decade later, the French people, when they heard (falsely) that Queen Marie Antoinette had replied to the shortage of bread amongst her minions with “Let them eat cake,” it served as a jolt to public opinion that would send many Frenchmen over the edge to the point of rebellion.

The elite in Brussels have grossly overplayed their hand, time and time again, by imposing sudden and dramatic change on the countries of Europe, whilst behaving arrogantly, bringing many of Europe’s people to the boiling point.

It Wasn’t the People That Joined the Unión

To add to the tyranny, no country’s population voted in a majority to join the union. Half-hearted referenda were undertaken by some countries, but voter turnouts were often poor. In other countries, the referenda were not binding. In the end, each government went ahead with only minority support and plunged headlong into a union that would benefit them, the leaders, but would not serve their people well.

The EU was, from its inception, the antithesis of “government of the people, by the people, for the people.” It was, instead, an “uber-government of the political leaders, for the political leaders, by the political leaders.”

All the above contributed to the likelihood (at least in my view) of a short-lived EU.

But the easy task is to predict the event. The more difficult task is to predict an approximate date, so that investment decisions and major life decisions may be timed to avoid the individual becoming collateral damage. The important question therefore would be, “What will be the trigger to begin the collapse?”

As the years passed and the cracks in the EU started to appear, the race was on as to whether the undoing would be as a result of the economic failure of the southern member states, or by the social strains of immigration that Brussels forced onto its member countries. In each case, it was predictable that the political leaders would defend the EU policies at all costs, although each would increasingly lose the support of constituents by doing so.

On the economic front, all eyes were on Greece and the other Mediterranean members, as they clung stubbornly to their collectivist economic policies. They would continue to bleed red ink at the expense of their more economically responsible northern brethren. Along the way, in order to appease her voters, German Chancellor Angela Merkel stated firmly that the EU would not bail out the Italian banks; that they would have to rely on bail-ins (a measure that had been approved in 2014 for all EU countries). Then the news came that the German Deutsche Bank was on the ropes, threatening to cause a bloodbath for the German people. Germany, having lost billions of its money to the other EU countries, would need $14 billion to pay for Deutsche Bank’s mis-sold mortgage-backed securities, and that would just be the beginning.

The German people had paid through the nose to support other EU members, but a line had been drawn in the sand as to future bail-outs, just before Germany realised its own crisis.

Suddenly, Mrs. Merkel has been caught between her obligation as chancellor to the German people and her personal commitment to the EU. Her problem is exacerbated by the fact that she is up for re-election in 2017.

Ironically, in the race for the collapse of the EU, it may be that the trigger that begins the process is Germany, the country that was most responsible for its creation.

The comparison with the Titanic is an apt one. Like the Titanic, the EU was presented as a “super-state,” one that would be bigger and better than all the others in Europe. It was declared unsinkable.

Yet, soon after it was launched, it hit an unexpected iceberg from which it could not recover.

Years from now, historians and economists will debate the identity of the EU iceberg. Some will say Brexit, others will say Deutsche Bank. Still others will cite events that we have not yet seen.

However, for our purposes, it matters little. The dominoes have begun to fall and all of us that may be impacted by an EU collapse should make sure that we have all our own ducks in a row—to assure that we are impacted as minimally as posible.