Sargen: A Tale of Two Countries: UK and France

Highlights

  • Theresa May’s decision to call an early election as Prime Minister has come back to haunt her:  Labor Party leader Jeremy Corbyn mounted a credible campaign that denied the Conservative Party a parliamentary majority.  The outcome has added to uncertainty about how the newly-formed British Government will negotiate leaving the European Union (EU).
  • By comparison, the political picture in France continues to improve, as Prime Minister Macron’s newly-formed political party posted a decisive victory in the parliamentary elections.  This outcome has boosted hopes that Macron will press forward with plans to overhaul France’s antiquated labor laws.
  • The contrast between the fortunes of the UK and France is striking.  Britain’s economy was among the most dynamic in Europe one year ago, but its future is now clouded by political dysfunction, whereas Macron’s election has raised hopes that France can transform its economy and stabilize the EU.
  • Amid these developments, we continue to favor continental European equities, but are wary of the UK due to political and economic uncertainty.

UK Elections: Another Surprise Outcome

For the second time in twelve months, the electorate in the UK has defied the pollsters, this time by denying Prime Minister Theresa May and the Conservatives a clear parliamentary majority in the British elections.  When May called for an early election two months ago, the initial assessment of pollsters was the outcome would cement the Tory Party’s majority in parliament, thereby strengthening her hand in negotiating Britain’s departure from the EU.

Instead, the opposite happened. The opposition Labor Party, led by Jeremy Corbyn, a staunch left-winger, mounted a credible campaign that attracted younger voters who had abstained from voting on the referendum to leave the EU.  As a result, May is now scrambling to see if the Conservatives can form a coalition government with a splinter party that represents North Ireland.

Investors are now focused on what the change in political fortunes means for Britain’s exit from the EU.  If May and the Conservatives had won decisively, investors were expecting a so-called “hard exit”, in which the UK would sacrifice free trade arrangements with the EU for increased national sovereignty.  Now that the Conservative’s hand has been weakened, other political parties are insisting on participating in the negotiations with the EU, and the outcome could be a “soft exit,” meaning Britain would seek trade and financial concessions from the EU while surrendering some sovereignty to obtain them.

Beyond this is another looming issue – namely, how will the UK be governed when it is deeply divided as a nation?  According to The Economist, Britain’s main political parties appear polar opposite in many respects:  “Jeremy Corbyn has taken Labour to the loony left, proposing the heaviest tax burden since the Second World War. The Conservative Prime Minister, Theresa May, promises a hard exit from the EU.  The Liberal Democrats would prefer a soft version, or even reverse it.”[1]  Yet, The Economist goes on to observe that the Tory and Labour leaders, despite differences in style and core beliefs, have one thing in common: “Both Mrs. May and Mr. Corbyn would each in their own way step back from the ideas that made Britain prosper – its free markets, open borders and internationalism.”[2]

Since the Brexit vote one year ago, the UK economy has held up better than many observers expected, as a 13% – 14% depreciation of sterling versus the dollar and euro have helped cushion the blow on exporters.  However, the latest indications are the economy is slowing, as real wages have stagnated and public funding is stretched. As a result, investors are becoming nervous about the country’s future.


France: More Positive Surprises

Meanwhile the political picture in France continues to improve, as President Macron’s newly-formed political party En Marche scored a decisive win in the French parliamentary elections on Sunday.  With Macron’s party gaining a clear majority in parliament, the 39-year old president is in strong position to enact his pro-reform agenda that includes weakening France’s protective labor laws, changing tax laws, and reducing pension benefits for some workers.  Moreover, whereas a year ago France appeared to be swept up in an anti-European, anti-immigrant wave, the nation has now rallied around a centrist and unabashed globalist, who seeks to strengthen the EU.

The key challenge Macron faces is whether he can make headway in reducing France’s high unemployment rate, which stands at 9.6% – the lowest in five years. For decades French politicians have tried to reform France’s antiquated system, which makes it prohibitively expensive to fire employees, only to back away in response to public protests. While only 8% of French workers belong to a union, 98% are covered by national and industry-wide contracts negotiated by unions.[3]  This arrangement is particularly problematic for smaller businesses that cannot negotiate terms on their behalf.

Macron is attempting to rectify the situation by making it easier to fire employees, capping damages in unfair dismissal cases and decentralizing collective bargaining.  At the same time, he plans to expand worker protections by making those who voluntarily quit their jobs eligible for unemployment benefits.  Macron’s goal of transforming France’s labor laws by the end of summer is considered ambiguous, and it remains to be seen how he will stand up to tumultuous strikes and protests.  That said, this appears to be the best chance to reform the system in decades.  Should Macron persevere, France hopefully would see the benefits of declining unemployment, much as Germany did when it enacted its labor reforms during the past decade.  Note: Germany’s unemployment rate currently is 3.9%, well below other EU members.


Investment Implications

Weighing these considerations, we continue to favor European equities, as political risks in EU have diminished while economic performance has improved. (See Time to Consider Europe, May 23, 2017)  That said, we would underweight UK equities on grounds the political situation has deteriorated and there is considerable uncertainty surrounding Britain’s exit from the EU.

Equity Markets:  France (CAC-40) versus UK (FTSE), January 2016 to Present

Source: Bloomberg. Local currency returns.

 


[1] The Economist, June 3rd-9th, 2017, p.13.
[2] Ibid., p.13
[3] See Catherine Rampell, “Macron attempts a feat that Trump wouldn’t dare,” The Washington Post, June 8, 2017.

Sargen: Time to Consider Europe

Highlights

  • Emmanuel Macron’s election as President of France has buoyed European markets, as it is the third election this year in which populist candidates have been defeated.  Moreover, with Angela Merkel’s party scoring key wins in regional elections, her chances of being re-elected in the fall are high.
  • In addition to lessened political risks, investors have been attracted by better-than-expected economic performance in the European Union (EU) this year.  Germany’s economy has been the locomotive, and Macron’s election has raised hopes that France will finally embark on much-needed structural reforms and that a renewed Franco-German partnership will revive the EU, as well.
  • Weighing these considerations, this may be a good time to add exposure to European equity markets: Profit growth has surged recently and political risk has lessened, while the discount on European stocks relative to the U.S. is in line with long-term norms.  The main risks are that Macron may not be able to deliver reforms and a populist leader could become Italy’s next President.

Background: EU Political Risks Lessen, while European Economies Improve

At the start of this year, a key issue relating to Europe was the prospect that elections in several countries – notably, Austria, Holland, France, Germany and Italy – could result in populist victories that would threaten the EU’s viability in the wake of last year’s vote in the UK in favor of Brexit.  France’s election was perceived to be the most important, because Marine Le Pen, the far right candidate, advocated that France should leave the EU and the euro.  While the odds of this happening were low, investor concerns heightened leading up to the first round elections, when there was a possibility Le Pen and far-left candidate, Jean-Luc Mélenchon, could be the two finalists.  In the event, Emmanuel Macron, a centrist politician who campaigned as a reformer, emerged as the front runner and went on to defeat Le Pen handily in the run-off.

In the wake of these developments, European equity markets rallied at one point by 5%, led by an 8% advance for the CAC.  The rally not only reflects investor relief that France will remain a core member of the EU, but also that the tide of populism on the continent has been contained:  The French election is the third in a row in which populist candidates were defeated, and recent state elections in Germany indicate that Angela Merkel’s prospects for being re-elected Chancellor appear very good.

At the same time, the EU has experienced better-than-expected economic performance, led by Germany: The 2.5% annualized rise in German GDP in the first quarter was the biggest in four quarters, and was well above potential (1.8% according to European Commission estimates.)  Investment in machinery and equipment also picked up in the quarter, suggesting a broadening of the expansion, which had been led by personal consumption.  German GDP in real terms is now 8.5% above its pre-crisis peak in 1Q 2008, well above other EU members.  Meanwhile, unemployment in Germany has fallen below 4% from a peak of more than 10% during the crisis.

For the EU as a whole, real GDP growth was 2% annualized, the best showing in the past two years. The improvement in growth is linked to the European Central Bank’s policies to keep interest rates near zero while expanding its balance sheet via asset purchases.  In addition, the 10% depreciation of the euro against the dollar in the past three years helped boost exports.

As in the United States, so-called “soft data” such as purchasing managers’ indexes and sentiment readings show a marked pick-up since the latter part of 2016.  Indeed, according to Credit Suisse, the latest PMI readings are consistent with EU growth accelerating to 3% (see Figure 1).  We would note, however, that hard economic data does not yet indicate the improvement in business sentiment.  Nonetheless, the latest EC forecast calls for the EU to grow by 1.7% this year, which is a considerable improvement from the past few years.

Figure 1:  European PMI Surveys Point to Stronger Growth 

Source: Thomson Reuters, Markit, Credit Suisse.

Another positive development is headline CPI has accelerated this year and is approaching the ECB’s 2% target, after running close to zero in 2015-2016.  This suggests the threat of deflation is waning, and the ECB can consider normalizing interest rates if this pattern continues.  That said, we believe the ECB will be very cautious about tightening monetary policy.


Will Macron Transform France and the EU?

To some extent, the boost in European equities since the first round of the French elections can be attributed to a relief rally that Marine Le Pen was not elected.  Beyond this, in the wake of Macron’s very decisive victory, some observers have asked whether the election could represent a turning point for France and the EU: Macron is a reformer who also seeks closer ties between France and Germany, which constitute the core of the euro-zone.

Soon after his election, Macron visited German Chancellor Angela Merkel, and both pledged to work closely to draw up a “road map” of reforms for the EU, including the possibility of implementing treaty changes, if necessary.  Merkel noted that work first needed to be conducted on reforms that are needed before changes in the EU treaty would be implemented.  One of the most important is the need for greater fiscal sharing if the EU is to evolve from a monetary union to a fiscal union. To go down that route, however, Germany wants to be confident France is committed to structural reforms that will make its economy more dynamic.  The reason: Germany undertook a comprehensive set of labor market reforms in the previous decade that are credited for reviving its economy.

For his part, Macron has called for a “revolution” to simplify France’s Labor Code, which is a 3,600 page document that regulates nearly every aspect of employer-employee relations.  This will not be easy to pull off, however, as he will encounter strikers and protesters, as previous French Presidents have.  For example, Francois Hollande, Macron’s processor, backed away from embarking on labor reforms in the face of stiff opposition.  Other reforms being considered include cutting the corporate tax rate from 33% to 25%, and reducing the size of France’s bloated government.  The latter goal, however, is modest, as Macron seeks to slow the expansion of government rather than to reduce its size, which is the largest among the leading industrial countries.

Having formed a new political party, Macron must first build a coalition with existing parties, so that he can gain a legislative majority in the parliamentary elections in June.  Those he has recruited so far lean strongly to the left, with many coming from the reform faction of the Socialist Party.  To appeal to the right, Macron is credited with making a wise choice of Édouard Philippe as Prime Minister.  Still, it appears unlikely Macron will win an outright majority, and he therefore may have to rule with a coalition.  Consequently, it remains unclear how successful he will be in achieving reforms that France desperately needs.

The Case for European Equities

The principal reasons for considering European equities are that (i) earnings prospects have improved with the economic upturn, while (ii) Macron’s election and the rejection of populism in several key European countries have lessened political risk.

The improvement in European corporate profits is shown in Figure 2.  It illustrates how far they lagged the U.S. market when economic growth trailed that in the U.S., and how they have improved recently.  Among developed countries, European stock markets traditionally have been the most levered to economic performance, and this continues to be the case, as earnings growth in Europe has exceeded that in the U.S. recently.  Moreover, the percentage of European companies beating expectations is the highest in a decade.  An additional factor supporting corporate profitability has been the weak euro.  Although it has firmed against the dollar recently, it is still relatively cheap on a purchasing-power basis.

Figure 2:  European Corporate Profits Lag the U.S. Until Recently
12-month trailing EPS, Index, Jan 2006 = 100


Source: Datastream, JPMAM. April 28, 2017.

On the surface, it appears European equities may offer good relative value, as the discount of European multiples to the U.S. is about 15%.  The latter, however, is close to the average of the past decade or so, when one takes into account differences in the sector compositions.  Therefore, we consider European equities to be reasonably valued relative to the U.S.

The other major consideration is that political risk in Europe has diminished considerably with Macron’s election and the likelihood that Angela Merkel will be re-elected Chancellor of Germany.  This has contributed to inflows of funds into European markets recently.  The principal risk for investors is disappointment that Macron may not be able to deliver on his reform agenda.  Another risk is that populism could resurface in the Italian presidential elections that must be held no later than a year from now.

Weighing these considerations, I believe now may be a good time to add to European equities, after years of being cautious about European markets.

Testimony on Monetary Policy

Mickey D. Levy (Chief Economist of Berenberg Capital Markets for the Americas and Asia) testified before the House Financial Services Committee on monetary policy.

He focused on how non-monetary factors including a growing web of government taxes, regulations and mandated expenses were harming the economy.

His line of thinking is of special note as these themes have been revealed over the years by CFS Divisia monetary aggregates and components.

His Testimony Resetting Monetary Policy is available online – http://financialservices.house.gov/uploadedfiles/hhrg-114-ba19-wstate-mlevy-20161207.pdf

Office of Financial Research Reports on Potential Threats to Financial Stability

The U.S. Office of Financial Research (“OFR”) reported that the U.S. financial system showed improved resilience over the past year but that it faces several threats stemming from global disruptions and “financial system evolution.” The findings were published in the 2016 Annual Report to Congress and in the 2016 Financial Stability Report.

OFR Director Richard Berner highlighted the key vulnerabilities uncovered by the reports:

“. . . Those created by global economic and financial disruptions, by continued risk-taking amid still-low long-term interest rates, by risks facing U.S. financial institutions, and by challenges in improving financial data.”

Both reports cited the following factors and developments as specific threats:

  • potential spillovers from Europe stemming from the long-term uncertainty posed by the Brexit vote;
  • credit risks in U.S. nonfinancial corporations posed by the rapid growth of high debt levels;
  • cybersecurity incidents stemming from electronic transactions;
  • the concentration of risk in central counterparties (“CCPs”) caused by clearing from CCPs;
  • pressure on U.S. life insurance companies;
  • systemic footprints of the largest U.S. banks and the substantial risks inherent in large bank failures; and
  • deficiencies in data and data management.

In the reports, the OFR also discussed the role of shadow banking in the financial system.

Lofchie Comment: A number of the systemic threats in the reports are due in large part to government intervention in the markets; e.g., the high debt levels that result from extremely low interest rates, and the increase in size of very large banks, which arguably is exacerbated by the costs of regulation that weigh most heavily on smaller firms.

The most notable threat acknowledged by the OFR is that which is created by central counterparties: “We are concerned that, although clearing swaps transactions through central counterparties reduces the risk from the other party defaulting in two-way swap transactions, it also concentrates risk in the CCP itself.”

“No kidding,” one is tempted to say. The government’s acknowledgment of this risk, which resulted from Dodd-Frank’s supposed magic bullet, is beneficial if remarkably belated. (Kudos to University of Houston Finance Professor Craig Pirrong, who predicted the threat many years earlier in posts on the Streetwise Professor blog.)

IOSCO Reports on Implementation of Post-Crisis Recommendations for Securities Markets

The IOSCO Board reported on the implementation of the G20/Financial Stability Board’s (“FSB”) post-crisis recommendations to strengthen securities markets. The Board report includes insight and analysis on the implementation of recent reforms and is based on self-reporting by national authorities in FSB jurisdictions. The report focused on (i) hedge funds; (ii) structured products and securitization; (iii) oversight of credit rating agencies; (iv) measures to safeguard the efficiency and integrity of markets; and (v) supervision and regulation of commodity derivative markets.

Highlights of the report:

  • hedge funds – all responding jurisdictions which permit or have hedge funds reported implementation of the G20 and IOSCO recommendations relating to registration, disclosure and oversight of hedge funds. Almost all reported implementation of recommendations in relation to international information and enhancing counterparty risk management;
  • structured products and securitization – most responding jurisdictions reported the introduction of measures to strengthen supervisory requirements or best practices for investment in structured products, and to enhance disclosure of securitized products as recommended by the Financial Stability Forum (now the FSB) in 2008 and IOSCO in a number of reports from 2009 onwards; and
  • oversight of credit rating agencies – all responding jurisdictions implemented G20/FSB recommendations to require registration and provide appropriate oversight of FSB jurisdictions in line with IOSCO’s Code of Conduct Fundamentals for Credit Ratings Agencies.

In addition, the report stated that the implementation of G20/FSB recommendations “is still progressing” in the areas of (i) measures to safeguard the integrity and efficiency of financial markets, and (ii) the supervision and regulation of commodity derivatives markets.

International Money: Interview with Professor Richard N. Cooper

Professor Richard N. Cooper – advisor to many U.S. Presidents on international monetary affairs – was recently interviewed by the Center for Financial Stability on his decades of experience at the center of international monetary policy.

Highlights include:

  • Evolution of the international monetary system,
  • Insights into Nixon Shock (cessation of the gold standard),
  • System of floating exchange rates,
  • Recent revelations regarding the 1944 Bretton Woods Conference,
  • China and measures to move forward,
  • Proposals for the future.

We thank Kurt Schuler and Robert Yee for such a wonderfully insightful exchange and Richard Cooper – Maurits C. Boas Professor of International Economics at Harvard and formerly Under-Secretary of State for Economic Affairs, and Chairman of the Federal Reserve Bank of Boston.

To view the full interview:
http://centerforfinancialstability.org/research/Cooper_Yee_0916.pdf

OFR Says “Brexit” Could Pose Risk to U.S. Financial Stability

The Office of Financial Research (“OFR”) asserted that “severe adverse outcomes in the U.K. from ‘Brexit’ could pose a risk to U.S. financial stability.”

In its biannual report, titled the Financial Stability Monitor, OFR provided the results of an assessment that focused on “vulnerabilities – weaknesses in the financial system that can originate, amplify or transmit shocks, potentially destabilizing the system.” The report was organized into five risk categories: macroeconomic, market, credit, funding and liquidity, and contagion.

The report found that risks to financial stability have stayed within the medium range, but also have risen as a result of the U.K. withdrawal referendum. The report specified that “Brexit” could pose moderate risks to the financial stability of the United States:

  • Trade: Although a recession in the United Kingdom or countries in the European Union would reduce the demand for U.S. exports, it is unlikely that the reduction would threaten U.S. financial stability due to the low percentage of U.S. exports to the European Union and vice versa. However, a reduction in exports could slow U.S. growth moderately.
  • Financial Exposures: The financial claims of the United States on the United Kingdom and, more broadly, the European Union could be vulnerable to losses due to (i) currency depreciations and volatility, (ii) declines in asset market prices, and (iii) increased defaults on debt claims.
  • Confidence and Indirect Effects: Financial instability in the United Kingdom or, more broadly, the European Union could do lasting damage to the confidence of global investors, and that damage could become “self-perpetuating.” Additionally, “U.S. long-term interest rates reached historic lows in the week after the [“Brexit”] referendum,” which in turn “underpin[ned] excesses in investor risk-taking.”
  • Funding and Liquidity Risks: Although “[k]ey funding risks are much lower than before the financial crisis due to major changes in short-term funding markets,” several vulnerabilities still persist. These include risks in certain money market funds and short-term investment vehicles, and sharp falls in market liquidity during certain moderate stress events.
  • Contagion Risks: “[C]ontagion risk is greater than available metrics indicate. . . . It is unlikely that the contagion risks disappeared as stress receded. It is more plausible that underlying factors – such as risky assets’ tendency to become more correlated during market stress – pose enduring contagion risks.”

The report stated:

Because the U.K. economy and especially the U.K. financial system are highly connected with the rest of Europe and the United States, severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability.

 

Lofchie Comment: The value of these government reports is questionable. Statements in the OFR report like: “severe adverse outcomes in the U.K. could pose a risk to U.S. financial stability,” are trivial given the current economic environment, and they offer no useful insight for market participants. More remarkable, however, was the failure of the Financial Stability Oversight Council (“FSOC”) to identify “Brexit” as a risk in its own annual report, produced just before the “Brexit” vote. The OFR’s biannual report and FSOC’s annual report raise necessary but basic questions: (1) are these agencies particularly skilled at identifying risks before the fact, and (2) do they have anything useful to say about risks after the fact?

Improbable Success

I am delighted to share the launch of Dr. Richard Rahn’s television documentary series “Improbable Success: Free Markets at Work” (www.improbablesuccessproductions.com). Richard is Chairman of the Institute for Global Economic Growth, and serves on the editorial board of the Cayman Financial Review.

At a time, when policies are increasingly encountering limits, Richard’s reflection on prior success stories is refreshing. At a minimum, contemplation of these ideas is vital, if we want to emerge from the present low growth trap.

Richard let us know that “For the past 17 years I have been writing a weekly column which appears in the Washington Times and many other places – and the world has only become worse. So, I decided that it might be useful to produce films of successful countries and the results of following good economic policies.”

The TV broadcast begins this Sunday, June 12 in 42 U.S. markets. Watch as Richard and journalist Emerald Robinson travel around the globe looking at unlikely success stories in countries that have beat the odds to become an improbable success. Chile, Switzerland and Estonia are the first three to be filmed.

I especially look forward to the show on Chile. I had the privilege of a front row seat watching the Chilean miracle unfold – from working on the nation’s last debt restructuring agreement to advising investors and corporates on trading and long-term investment strategies. In fact, CFS Advisory Board Member Eduardo Aninat deserves much credit for steering and guiding Chile to growth during his tenure as Finance Minister.

Singapore is another wonderful story. Nearly ten years ago, I heard Lee Kuan Yew engagingly discuss the varying struggles and ultimate drivers of his nation’s success at the Singapore Economic Club. These ideas and many others are chronicled in his book “From Third World to First: The Singapore Store: 1965-2000.”

Needless to say, I look forward to watching the “Improbable Success” and thank Richard and Emerald in advance, for their work. Specific viewing times and further information, visit Improbable Success Productions website (www.improbablesuccessproductions.com).

NY Federal Reserve Bank President Cites Progress in Cross-Border Regulation

Federal Reserve Bank of New York President and CEO William C. Dudley voiced optimism about the “substantial progress” made in “strengthening the global banking system.” He cited the establishment of capital and liquidity standards for internationally active banks as an example. In addition, he noted that “steps have been taken” to respond to the failure of systemically important financial firms on a cross-border basis.

Even so, Mr. Dudley asserted, “more needs to be done.” His recommendations include: (i) identifying and dismantling the impediments to orderly cross-border resolutions, and (ii) enhancing cross-border regulatory cooperation through the “greater exchange of confidential supervisory information so that national regulators can be fully informed about the conditions of the banks that operate within their borders.”

Mr. Dudley asked the following questions, which he said were raised by the idea of a convergent transcontinental economy:

  • Can policy strategies ensure that the global economy will escape from this long period of low inflation and real interest rates? If so, what are those strategies?
  • Does fiscal policy have sufficient scope to assume part of the burden of ending this period of persistently low inflation and interest rates?
  • Is the economy going through a period of secular stagnation or is it simply at the midpoint of a deleveraging process that will dissipate gradually?
  • Why hasn’t investment spending reflected the low level of interest rates?
  • What underlying factors have contributed to the recent slowdown in the growth of global productivity?
  • Is it possible for Europe to realize a banking union with a common deposit guarantee scheme?
  • Are there practical opportunities for furthering additional regulatory and supervisory convergence between the United States and Europe?

Mr. Dudley delivered his remarks at a conference hosted by the European Commission, the Federal Reserve Bank of New York and the Centre for Economic Policy Research: “Transatlantic Economy: Convergence or Divergence?”

Lofchie Comment: Since Mr. Dudley is pondering the lack of growth in investment spending and whether the economy is going through a period of secular stagnation, the ideal question for him to ask might be this: are there regulations that are materially damaging to economic growth? New rules have imposed billions of dollars’ worth of compliance and transactional costs. Many of those rules are not particularly sensible and a fair number are actually destructive. The time for regulators to exercise self-criticism is long past due. Unfortunately, too many seem to believe that economic growth can be achieved only by adding more regulations, without first conducting a meaningful analysis of which rules might work, which rules might fail, and which are not worth the costs their implementation would demand.