Quarterly Investment Strategy  

19/04/2017

Strong economic signals bucking “make or break” political risks

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History books will remember 2016 for the “Brexit” vote, Donald Trump’s election, and more generally political U-turns driven by popular exasperation. Investment-wise, we actually consider the hallmark of the past 18 months to be the worldwide upswing in nominal growth. The recovery of the largest, most resource-dependent economies of the emerging world is emblematic of the cyclical revival in global growth.

History books will remember 2016 for the “Brexit” vote, Donald Trump’s election, and more generally political U-turns driven by popular exasperation. Investment-wise, we actually consider the hallmark of the past 18 months to be the worldwide upswing in nominal growth. The recovery of the largest, most resource-dependent economies of the emerging world is emblematic of the cyclical revival in global growth.

We see no risk of recession in the Western world this year. Recessions are typically preceded by the imbalances arising from an investment boom or excess credit growth – both being absent for now. The lesson of 2016 could thus well be that political shocks often have limited economic consequences. That said, and quite understandably considering its potential impact on the future of the single currency, investors remain very much concerned about the upcoming European electoral agenda. A number of other risks are also currently perceived as having major disruptive potential.

Should we worry about a Eurosceptic government?
Focusing on the ultimate issue, namely the possible holding of a referendum on European Union/Eurozone membership, we see European electoral risk as contained. Eurosceptic parties are on the rise, but still far from calling the shots. With most elections held under the proportional system, favouring coalition-making, even where such parties rank well (Netherlands, Italy), they have no clear path to forming or being part of a government.

In France, the double two-round system drastically limits the odds of the Front National achieving its “Frexit” goal. We play devil’s advocate, imagining a scenario in which Le Pen first wins the presidency (30% odds according to recent polls), then secures sufficient parliamentary support to hold a referendum on Eurozone membership (unlikely) and then manages to convince half of the French people to vote “leave” (equally unlikely). We arrive at a cumulative probability of only 7.5%.

Should we worry about US protectionism?
Trade was a signature issue of the Trump campaign and the new administration seems intent on maintaining a hard line. Unlike other campaign promises, however, no tangible measures have been announced thus far (beyond the withdrawal from the Trans-Pacific Partnership (TPP) agreement, whose impact we view as limited), offering some reassurance to financial markets that the worst outcomes will be avoided.

Caution is nonetheless still warranted. A full-scale trade war, with large trade barriers being erected by the US and its trade partners retaliating in kind, would be a damaging economic force – for both the countries facing such measures and that taking them.

The expected renegotiation of the North American Free Trade Agreement (NAFTA) will be as an important signpost. Is the US’s aggressive stance only a means of obtaining modest concessions or could the process result in the treaty being scrapped? For now, our base case remains that US prospective protectionist policies will not undermine growth.

Should we worry about a return of consumer price inflation?
The global economy is entering a reflationary sweet spot, where deflation risks have abated and fears of excess inflation not yet surfaced.

Two potentially inflationary forces do stand out: the retreat from globalisation (which enabled greater domestic demand to be met by more imports rather than higher prices) and the swing from fiscal austerity to more expansive public spending.

However, with productivity and labour force growth still weak across the globe – and likely to remain so – reflation should not morph into an inflation scare. Inflationary pressures only tend to build when an economy achieves faster than potential growth (which we estimate at 1.5% for the US and 0.8% for the Eurozone), and really accelerate when the output gap exceeds 2%. For now, above 3%, respectively 2.5%, growth in the US and Eurozone seems a far cry.

The unemployment gap, currently near zero in the US and still open in the Eurozone, also argues against an intensification of inflationary pressures. A drop in the unemployment rate below 4.0% in the US or 8.0% in the Eurozone would be worrisome – again, not an immediate prospect.

Should we worry about a collapse of the Chinese economy?
Trade and investment ties make China the most important economy for the emerging world at large. As such, being confident that China will not collapse economically is key to our reflationary scenario.

While fears of a hard landing were (unduly) elevated last year, the Chinese economy seems to have found its footing, supported by a variety of policy measures. Risks are admittedly present, but so are a number of mitigating factors.

Private consumption for instance is now the primary driver of Chinese growth – and continues to post healthy progress. In the real estate sector, while house prices appear to have peaked, high savings and low mortgage debt (thanks to typically large upfront payments) ensure that conditions remain sustainable. At the corporate level, excessive debt accumulation is more worrisome, but there again the high domestic savings rate – together with the current account surplus – keeps the issue manageable for the time being. Finally, since a sharp renminbi depreciation has been a prominent market concern, it is worth highlighting that although the currency has lost significant ground against the US dollar (ca. -14% since 2014), it has remained roughly flat in trade-weighted terms over the same period.

All told, (excessive) hard landing fears in China have abated and the lower energy cost-driven reflation thesis still has legs – while spiralling inflation, protectionism or the European electoral agenda are threats rather than actual headwinds at this stage.

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