Oil prices have responded to political volatility in the Gulf.

In 1973, Egypt and Syria launched a surprise attack on Israel during the Jewish religious festival of Yom Kippur. The swift arrival of arms from the US helped Israel repel the assaults.

Opec nations, upset at US support for Israel, cut oil production and placed a sales embargo on the US and any European country that helped Washington funnel arms to Israel. Oil prices surged nearly 400% over the next 12 months in what became known as the first oil shock of 1973-74.  The result was the stagnation of the 1970s.[1]

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France’s turbulent politics make economic reforms tricky to implement: Fidelity

While the plan to unify Europe after World War II began with two Italians,[1] the French pounced on the idea. The first concrete step occurred in 1950 when the French government called for the creation of a unified military in western Europe as a step towards a political federation along the lines of Australia’s. The same year Paris proposed the joint administration of French and German coal and steel resources to shift these war-making ingredients out of German control.

The six-member European Coal and Steel Community that was formed in 1951 is considered the birth of the EU. Its “common assembly” is now the European parliament. Along the way, the French drove the creation of the euro, a currency Germany adopted to gain Paris’ support for German reunification in 1990.

But the fate of the proposed pan-European military force could provide more lessons for what lies ahead for the eurozone. In 1954, the French parliament failed to ratify a treaty allowing the military pact, in part due to concerns about threats to French sovereignty. With it went any chance of forming a proper federation across Europe.

Over the years, the French have taken other steps to stymie European integration. In 1961, Paris vetoed the UK’s admission into the then European Economic Community. In 1964, Paris sabotaged a US-led effort to form a political and military union across Europe by making economic threats to thwart German participation. In 2005, it was the turn of French voters to reject European integration, when they voted against a treaty designed to transfer more power from national to central control.

The danger for Europe is that France’s ailing economy is making its politics volatile and as antagonistic towards Europe as it was during these episodes. It’s possible that a collapse of support for the ruling Socialist party and an intra-party rebellion that led to the government’s dissolution in August, a paralysis of French leadership in Europe, Paris’ policy frictions with Germany and the rise of populist parties at a time when France’s right-wing mainstream party is mired in corruption scandals will block or even reverse the meshing that Europe needs to restore its prosperity. The political climate could even lead to France quitting the euro.

Given how much the French have woven Europe together, it’s hard to believe a French government under the mainstream political parties would torpedo the euro, unravel Europe’s integration or idly allow outside forces to wreak similar damage. Any economic recovery could derail the rise of populist nationalistic forces. In the past, France and Germany fought over policy even as they integrated Europe. Surely, they can weld Europe closer together nowadays even as they stoush over solutions. The truth, though, is that France’s politics are haywire enough for the country to pose indirect and direct threats to the eurozone and the euro in particular.

Woes and blows

France’s political turmoil is due largely to its economic ills but it also stems from the country’s long disquiet about globalisation because of the challenges modernity poses to uncompetitive monocultures and the power of “the state”, which has elevated status in France.

France’s high-tax, over-regulated, protectionist and government-heavy economy – public spending amounts to a eurozone-high 57% of GDP – is sick enough and big enough to threaten any European recovery as the country of 63 million amounts to 16% of the eurozone economy. France is basically in its sixth year of recession or near recession. The economy is barely above its size in 2007, having recorded zero growth in 2012 and a meagre 0.3% rise in 2013, partly because the government is imposing austerity.[2] Concerns about deflation are mounting – French consumer prices only rose 0.6% in the 12 months ended July this year. Unemployment is hovering around 11% or 3.4 million registered jobless. The ratio of government net debt to GDP has soared to 97%,[3] even though (or perhaps partly because) Paris has withdrawn stimulus worth an estimated 5% of output over the past three years. Labour costs rising at triple Germany’s rate over the past decade (30% versus 10%) have made the country less competitive and it now runs a persistent current-account deficit.

France’s economic woes have helped make François Hollande the country’s most unpopular president of the Fifth Republic that began in 1958 – his approval rating is just 13% – even more so now he has upset his Socialist Party supporters by untangling France’s rigid labour market and giving business tax cuts. France’s economic troubles and Hollande’s poor standing have led to Paris exhibiting little sway in eurozone political decisions that could have long-term consequences. Hollande, for instance, was absent from the debate over appointing federalist Jean-Claude Juncker as EC commissioner in July, even though UK Prime Minister David Cameron warned that Juncker’s selection could lead to the UK pulling out of the EU.

The divergence between the economic performance of France and Germany is leading to clashes within the partnership that wove European integration. One big quarrel is over fiscal policy. France’s central government, which hasn’t recorded a budget surplus since 1974, is struggling to meet EU laws to rein in its budget shortfall to 3% of GDP by 2015. The desire by Paris (and Italy) to loosen Europe’s fiscal compact of 2012 angers Berlin, which is mustering economies in far worse shape than France to comply with the financial oversight it has implemented to protect German taxpayers from bills to backstop the euro.

The other big collision is over monetary policy. France wants the European Central Bank to engage in quantitative easing to stave off deflation, help fight unemployment and undermine the high euro. Germany, with its inflationphobia, expanding economy and less reliance on price-sensitive consumer exports sold outside the eurozone, rejects such demands. Berlin thinks that, as well as risking inflation, ECB asset-buying will allow France and other laggards to ease back on structural reforms – in strike-prone France’s case, such measures include trimming the public sector and labour reforms. Given such tensions, it came as no surprise when Germany in July blocked France’s push to install its former finance minister Pierre Moscovici as the EC commissioner for economic and monetary affairs.

The Paris and Berlin clashes, which extend to disputes over other remedies such as EU-financed stimulus spending, eurobonds, a fiscal union and a banking union, pose an indirect but existentialist threat to Europe. If the two biggest euro-using economies are feuding, hopes fade that eurozone countries can agree to the political decisions and compromise that are needed to nurture Europe through its debt crisis. “A crisis in (France) could … push the eurozone to breaking point,” warns UK-based think tank, the Centre for Economics and Business Research.[4]

The target

French politics is an even bigger direct menace for the euro, even if that dénouement might still be three years away and it might appear a low possibility. But, if the threat materialises, it will be lethal for the euro. The peril stems from the collapse in standing of the two mainstream parties, the centre-right Union for a Popular Movement (UMP) and Hollande’s Socialist Party, and the simultaneous rise of Marine Le Pen’s populist, right-wing and euro-hating National Front. So upbeat is Le Pen, now almost the de facto opposition leader, she hopes to win the presidency in 2017.

Le Pen’s optimism is based on the triple shock that France’s political system suffered in May that The Economist says “could affect French politics for years”.[5] The tremors were that the National Front won the European elections after garnering 25% of the vote, the Socialist Party scored its worst result at a national election, receiving just 14% support, (after having flopped at council or local elections in March), and a party-financing scandal ripped through the UMP and forced its leader, Jean-François Copé, to resign.

Since then things have got worse for France’s political elite that Le Pen paints as corrupt, out of touch, uncaring and incompetent. For the UMP, the post-election blow came on July 2 when former French president Nicolas Sarkozy (2007-12) and, still a possible UMP 2017 presidential candidate, became the first former head of state to be detained in a criminal investigation, which led to charges against him of corruption and abuse of power. Sarkozy’s defence that he is being set up by a rotten state, judiciary and police, implicitly justifies Le Pen’s venom towards the political class.

For the Socialists, there have been two post-election lows. The first occurred on August 25 when a left-wing revolt erupted over adhering to austerity policies. Arnaud Montebourg, then minister for the economy, sparked a crisis when he rebelled against the “absurd” austerity policies that spring from the “excessive obsessions of Germany’s conservatives”.[6] Hollande’s order for Prime Minister Manuel Valls to form a pro-austerity cabinet, the fourth of his presidency, pits the government against the social unrest brewing over fiscal stinginess. (France has a so-called semi-presidential system, where the cabinet, though controlled by an elected president, is responsible to parliament. The government needs to be dissolved to allow a cabinet reshuffle.) The other post-election nadir came in early September when Hollande’s former partner, Valerie Trierweiler, triggered a political storm when she published a tell-all book of her relationship with the president.

France’s austerity bias will drag on the economy. Its turbulent politics make economic reforms tricky to implement. So it’s hard to see the country bursting out of its malaise. Some of what irks the French is tied to Europe’s integration and its flawed currency. Of note in this category are Europe’s open borders, petty ruling from Brussels that annoy voters, austerity and the free-market bias of the EU. But much of what riles the French is more tied to globalisation. Job losses to emerging countries, the resulting insecurity about employment and conditions in France, the threat to the welfare state from the need to boost competitiveness, the shrinkage of French’s global power, the dwindling of the state’s reach within society, rising inequality and the buffetting (Americanisation) of the traditional French way of life would exist without the EU and the euro.

Le Pen’s danger to Europe is that she is talented enough to direct all French angst, no matter its source, against one enemy and to get away with posing just one solution. Her political chicanery is to blame all France’s woes on the euro (admittedly, Europe’s biggest post-war mistake). Her remedy is to restore the franc. How Europe would cope if France were to ditch the euro is anybody’s guess. (Some analysts advocate breaking up the eurozone to save the EU.) Investors and others will need to form their own judgments if polls show Le Pen is heading towards the presidency – in July she took the lead in the first-round polls for this election; in September she beat Hollande in a second-round matchup, according to one polls.[7] Just beware that if Le Pen should win, she has pledged that on her first day in office that she will take steps to rid France of the euro and that she is willing to let “financial Armageddon” rip if other eurozone countries won’t agree to a joint breakup. “What are other countries going to do (to stop me),” she taunts. “Send in tanks?”[8]

by Michael Collins, Investment Commentator at Fidelity

———–

French economic statistics largely come from the IMF’s World Economic Outlook Database. Other financial information comes from eurostat, Capital Economics and Bloomberg unless stated otherwise. The history of France and the development of the EU largely comes from Brendan Simms’ book Europe, the struggle for supremacy 1453 to the present. (Allen Lane 2013).

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US recovery going strong.

Some may be surprised that US stocks took just over 5 ½ years to regain previous highs after the so-called Great Recession compared with the 25 years it took the Dow Jones Industrial Average to recover from the Great Depression.[1]

The losses triggered by the US sub-prime crisis were recouped on 10 April 2013, when the S&P 500 Index climbed back to the pre-Lehman-crash intraday high of 1,576.09 it set on 11 October 2007. Since that April day last year, the bellwether US index had added another 22% by July 31 just gone when it ended at 1,930.67.

Amid some talk that central-bank asset buying is fuelling asset bubbles including stock prices, there is a more fundamental reason why US stocks are at record highs; healthy earnings growth. In fact, profit growth has been so strong that US profits have reached a record share of GDP, at the expense of wages.

The encouraging news for US stock investors is that earnings are poised to grow in absolute terms in coming years as the US economic recovery appears durable, even as some of the forces that have driven earnings growth become less helpful. If there’s any link between profits as a percentage of GDP and share prices, then investors can look forward to more years of a rising S&P 500 Index, for chances are that profits as a percentage of GDP will crack fresh record heights in the coming era.

The US economy could, of course, crumble and retard earnings growth. Some other shock could sink shares. Quantitative easing, which shaves longer-term interest rates, played some role in helping stocks so any rise in long-term yields due to its upcoming end could dampen enthusiasm for stocks. There is no ironclad relationship between stock prices and earnings as a percentage of GDP. Profits can never reach 100% of output so there must be some limit to their rise on this basis against wages, even aside from the political consequences that steeper inequality would inspire to reverse the shift. Analysis that focuses just on earnings doesn’t necessarily take into account what’s already priced into share prices. But overall, if the outlook in coming years is one where earnings rise in absolute and in relative terms, the environment for stocks will be more inclined to be favourable.

At labour’s expense

US earnings have risen in recent years largely because supportive low interest rates and overlooked fiscal stimulus have engendered an economic recovery that has just entered its sixth year.[2] US companies have enjoyed low short-term interest rates since December 2008 because the Federal Reserve was quick to slash the cash rate to close to zero to make borrowing costs out to five years as favourable as possible for business once Lehman Brothers collapsed. To ensure longer-term borrowing rates supported the economy, the Fed embarked on three quantitative-easing or asset-buying programs; from 2008 to early 2010, from late in 2010 to 2011 and since 2012.

In economic terms, these low interest rates made more businesses profitable, reduced company debt repayments and encouraged consumers to spend. As far as the stock market goes, puny interest rates justify higher valuations such as elevated price-earnings ratios. Low bond yields prompt investors to look for higher returns from other asset classes – in particular, they helped property and infrastructure stocks whose bond-like qualities make them proxies for fixed income when yields are negligible. Low rates fanned IPOs and M&A activity that are fuel for stock rallies. They encouraged investors to re-rate mediocre companies to higher multiples. They prompted asset allocators to switch money away from rising assets – in this case, bonds – to stay within strategic limits. Lastly, low interest rates combined with pledges by central banks to keep rates low appear to have engendered a complacency about the outlook that is reflected in low readings on volatility, which in turn helps shares. A more stable outlook for prices justifies paying a higher price for an asset and the price stability attracts other, warier, investors. As the low cash rate has the most powerful spurt for the economy and stocks via its dampening effect on bond yields out to three to five years, the ending of the Fed’s asset-buying in coming months shouldn’t be detrimental to stocks. Any unforeseen jump in the cash and thus other short-term interest rates, however, would be harmful.

On the fiscal side, the boost to the US economy and US stocks is staggering when the sum is totalled over the past five years. From 2009 to 2013, US federal fiscal stimulus amounted to 41% of US GDP in aggregate.[3] This US$7.1 trillion (A$7.5 trillion) equivalent of stimulus at 2014 prices[4] that ranged from tax credits to “shovel-ready” projects helped fill the demand void created when workers lost their jobs and businesses and households focused on reducing their debts rather than spending, even if US state governments reduced the stimulus a touch by imposing austerity policies to meet laws that required budgets to be balanced. The US recovery has been robust enough to survive the austerity imposed by Congress over the past year or so. These cuts and higher tax receipts are expected to help lower the fiscal deficit to below 5% of GDP this year from a peak of 10% in 2010.[5]  

Three other forces that boosted earnings growth are worth mentioning too. The first is that companies engaged in cost-cutting to protect margins. Another is that technological improvements allowed business to become more efficient; in economic jargon, innovation cut the labour intensiveness of production. Goldman Sachs analysis shows that from 1998 to 2011 the ratio of spending on technology to labour grew in auto, oil and gas, communications, mining, retail, wholesale trade and warehousing. The other boost is that globalisation created fresh foreign markets for US companies and eased access to long-standing ones. In 2012, US companies earned 21% of their profits from abroad, triple the 7% share recorded in 1969, according to the US Bureau of Economic Analysis.

These stimulants helped US profits expand at a much faster rate than earnings did in other developed countries in absolute and relative terms – hence the outperformance of US stocks in 2012 and 2013. Minack Advisors says profits at US listed companies surged from about 3% of GDP in 2009 to about 5.5% of output in early 2014, while listed profits in other developed countries have only hovered around 3% of GDP over the past five years.[6]

This jump in US earnings has boosted the share of profits from all US companies to a record 11.1% of GDP at the end of 2013, according to the Federal Reserve Bank of St Louis, compared with an average of about 6.4% since 1947. At the same time that US profits have soared, the percentage of wealth heading to workers declined to 43% of GDP at the end of last year from a peak of 52% in 1969 and from an average of 47% since 1947.[7]

There is one key reason why increased US profits have headed to shareholders at the expense of workers. Labour has lost its bargaining power over the past 30 years as right-wing ideology triumphed and globalisation expanded the pool of cheap workers for hire, and thus lowered wage pressures. Labour’s negotiating power weakened ever more during the Great Recession, when the jobless rate peaked at 10.0% in October 2009 when looking at the most-watched (U-3) measure, or at 17.2% in April 2010, when looking at the wider (U-6) gauge that includes reluctant part-timers and those dropping out of the workforce in despair.[8]

Piketty’s insight

Even after five years of recovery, there’s no sign that US wages are rising in real terms, let alone relative to GDP, even though the most-watched jobless rate was 6.1% in June just gone, when the wider unemployment measure stood at 12.1%. This wage stagnation reflects job insecurity and the fact that many middle-class jobs have been replaced with poorly paid, even part-time or temporary, ones. Fed Chair Janet Yellen in April even remarked on the “historically slow pace” of wages growth in this recovery.[9]

Even if wages were expanding at a pace to trouble inflation, it would be hasty to assume – as fans of mean reversion seem to – that somehow US profit share will drop towards its long-term average, or even lower. There’s no automatic force in play that returns the profit and labour ratios to GDP to some fairer equilibrium. Outside of wars and other such catastrophes, financial or otherwise, that destroy wealth, only human endeavour that coalesces into a political force capable of effecting changes in labour’s favour can eat away at profits’ share in GDP.

The money in US politics that buys the rich a veto over threats to their wealth, recent Supreme Court decisions empowering the political power of this cash, another high-court decision that eroded the ability of unions to collect fees from all the workers they cover, the weakening of minimum wage standards at state level even amid a push to raise the federal minimum hourly rate and the ability of business to get away with underpaying staff are just some of the forces suppressing wages growth and wages’ share of GDP in the US. The probability is high that Republicans will regain control of the Senate and hold the largely gerrymandered House of Representatives in Congressional elections in November. These results would only add to the power that capital has enjoyed over labour since the early 1980s no matter which party controlled Congress or the White House.

On top of these political pressures, workers face a sub-par economy – it expanded at an annual pace of about 2% in the first six months of 2014. For an historical perspective of how the pace of economic growth affects the relative splits of wealth and income between capital and labour, investors can turn to the book by French economist Thomas Piketty Capital in the Twenty-First Century, an analysis of inequality that is topping best-seller lists.[10]

Piketty has tracked inequality since the 18th century by looking at the breakup of wealth and income across key western societies. His findings on the US show that the recent political shift in favour of capital is pushing inequality towards its peak in 1910 for capital[11], when the top 10% owned 70% of wealth, and its highest for income[12] which was around 2007, when the top 10% earned just under 50% of income. (Income’s previous peak was in the late 1920s. Inequality fell over the middle of the 20^th century because world wars, a Great Depression and government intervention in the form of higher taxes and increased welfare payments made for a more egalitarian society.)

Piketty’s central thesis, which is grounded more in observation than theory, is that the returns flowing to the owners of capital grow faster than GDP and this fact means that capitalism’s natural state is one where inequality rises. Over time, the return on capital is, say, 3% to 7% (profits, dividends, rent, etc.) versus about 1% to 2% for economic growth (and thus wages). Other things being equal, the slower the economic growth, the faster inequality rises. “It is an illusion to think that something about the nature of modern growth or the laws of the market economy ensure that inequality of wealth will decrease and harmonious stability will be achieved,” Piketty says.[13]

The US outlook is only one of modest economic growth – the recovery is robust enough to survive a decline in fiscal stimulus and less promiscuous monetary policy. No political forces are marshalling to tilt laws or regulations in labour’s favour. Therefore, capital’s saunter to a second Gilded Age appears unhindered for now. That’s better news for investors in US stocks than US workers in coming years.

Financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

———-

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Global threats are mounting: Fidelity

The hazards confronting the world economy are mounting. The US economy is recovering at an unspectacular pace of about 2%[1] and a sub-par labour market, sluggish wages growth, renewed doubts about the housing market and weak demand for the country‘s exports only portend more modest growth ahead.

On top of this, inflation is accelerating, the Federal Reserve is only months away from ending its asset buying and rate increases appear inevitable before too long. The defeat of House majority leader Eric Cantor in a Republican primary election in Virginia in June by a Tea Party candidate is expected to cement gridlock in Washington and could lead to more showdowns on raising the government’s debt ceiling. The eurozone is still in recession,[2] disinflation could fester into deflation, government debt loads are at default levels and banks are so crammed with dud loans they are restricting lending, while some are wobbling in Austria and have failed in Portugal. Even if European Central Bank Governor Mario Draghi’s bluff to protect the euro is soothing investors, the financial crunch in the eurozone has morphed into a political crisis revolving around a jobless emergency that is fanning support for nationalistic and fringe parties, the opposite environment needed to create the political jelling the euro needs to assure its survival. Housing is bubbling in countries from the UK to New Zealand.

The emerging world isn’t in much better shape, especially as it is riddled with conflicts. A civil war has broken out in Ukraine, only months after Moscow seized Crimea from its neighbour, and Russia could yet invade. Western sanctions against Moscow in response will damage more than Russia’s economy. In the Middle East, Syria’s civil war rages on. Islamists control much of northern Iraq and a third of Syria and the fighting pitting Shias and Sunnis could spread into other countries such as Jordan. Israel has been to war against Gaza for the third time in six years. Iran could still gain nuclear weapons. In Africa, Libya has become ungovernable. In Asia, China is creating tension, especially with Japan, as it seeks to broaden its ownership of the China Seas. Due to China’s flexing, military spending in Asia has inklings of an arms race. Nuclear-primed North Korea is as loony as ever while nuclear-armed Pakistan grows more unstable.

Financial and economic challenges are no-less menacing in the developing world. Argentina has defaulted for the second time in 13 years after a legal feud with “vulture funds”, an outcome that will damage South America’s second-largest economy. China’s property market is deflating, while Beijing is only making half-hearted attempts to police out-of-control lending because it worries that proper regulation might make the country miss its 7.5% growth target. So challenged are many emerging countries by current-account deficits, inflation, sluggish economic growth and plunging currencies that labels of the past such as BRICs that flagged the potential of developing nations have given way to “fragile” plus a number; i.e., the “fragile five” are Brazil, India, Indonesia, Turkey and South Africa.

Could any of these challenges morph into a shock as damaging as the collapse of Lehman Brothers in 2008? Or could some other threat not yet evident emerge? Maybe it will be a jump in interest rates. Some analysts say it’s only a matter of time before Saudi Arabia is engulfed in the political turmoil of its neighbours. Just think what that would do to oil prices. Whatever form any shock could take, if one should occur, it’s not so much the shock that should worry investors. It’s the powerlessness of authorities to respond. There is, however, one hope that shines out from the events of recent years.

It must be said that there are always dangers to the global outlook and most of them are overhyped and fizzle out. So most likely will today’s perils. Since World War II, global politics has been far more volatile than today, even when the nuclear armed superpowers confronted each other as during the Cuban missile crisis in 1962 or the Yom Kippur War of 1973 that led to the first oil price shock of the 1970s. Even amid all the current hazards, the World Bank still expects the global economy to expand this year, even if that expected pace of growth for 2014 was reduced to 2.8% in June from the 3.2% forecast the bank made in January.[3] Other good news is that inflation is only a menace in a few countries. Japan’s radical economic experiment is going well so far. In India, the dominant election victory of BJP has sparked hopes the government can enact reforms that will rejuvenate the world’s second-most-populous country. Indonesia, the world’s biggest Muslim country that only 15 years ago was an economic and political basket case, is expected to advance further under new president Joko Widodo. US banks are better capitalised and are under tougher regulation. Across the globe, current accounts are better balanced, thus removing the savings mismatch that was a key cause of the global financial crisis of 2007-08. Any shock these days would have to be huge to outdo the jolt to consumer and business confidence that was inflicted by the collapse of Lehman Brothers, most likely a once-in-a-generation event, for people are hardened to alarms nowadays. Even allowing for all this, though, the world appears more precariously placed to cope in the unlikely event of a shock than it was six years ago.

All together now

When the US sub-prime crisis morphed into a global financial crisis in September 2008 policymakers in affected countries responded almost in unison. Central bankers slashed interest rates. They provided emergency funding to banks. Those in the US and the UK embarked on unprecedented asset buying or quantitative easing, a cure invented by the Bank of Japan in 2001. Political rulers provided massive fiscal stimulus. They nationalised banks. They guaranteed bank deposits even, mistakenly in Ireland’s case, backed bank debt.

These steps succeeded in avoiding another Great Depression, a feat in itself, but some harm was unavoidable and unintended consequences arose. The resulting Great Recession ushered in double-digit jobless rates while low interest rates fanned housing and other asset bubbles around the world. Policymakers made mistakes too. Austerity policies implemented in Europe and elsewhere have hobbled economies, boosted the ranks of the jobless and worsened government debt levels. The ECB could well turn to asset buying too late to stave off deflation.

These side effects and errors could add to the severity of the next downturn in the unlikely event of a shock. The greater problem, though, is that if another jolt comes authorities are much more handicapped than they were six years ago. Most of the steps that supported economies and banking systems in 2008-09 have lost their muscle. Major central banks already have reduced cash rates to record lows, so on this score they are immobilised. Quantitative easing has been unmasked as no miracle cure, even if it can help avoid a catastrophe or deflation. Research in 2012 out of John Hopkins University found that any reduction in interest rates from asset-buying programs was fleeting and “quite modest”.[4] While other studies might be kinder to central-bank asset purchases, it’s hard to believe that the Fed would do much for the economy if , say, it restored its monthly asset buying to US$85 billion again to limit shockwaves. Such a policy retreat might even deal another blow to confidence for the Fed and other key central banks have swelled their balance sheets to levels that approach the limits of investor tolerance, or at least to levels that provide fodder for scaremongers. The new (old) world of macroprudential controls, or financial regulation, to fight asset bubbles is fraught because it injects central bankers into the centre of political decisions.

Politicians and the executives they control appear just as toothless. Many governments are so debt laden they would be challenged to pursue the fiscal stimulus matching that of 2008 to 2010. Net debt sits at 74% of GDP for advanced economies, about where the average stands for the 18-member eurozone.[5] The US government net debt has reached 82% of output, while Japan’s ratio has soared to 137%. The straightjacket that such ratios put on governments is shown by events in Japan. Fiscal pressures forced Tokyo to raise the sales tax by three percentage points in April this year, a move that acts against the consumer spending that propels the economy, thus jeopardising the gains won so from the radical monetary experiment to engender inflation and economic growth. The US debt pile is the defining restriction on Washington’s ability to stimulate the US economy, which post-2008 was helped by annual fiscal deficits averaging 9.2% of GDP from 2009 to 2011.[6] The fight over US government finances has already produced the brinkmanship over the so-called fiscal cliff and two debt-ceiling showdowns that took the country to the brink of default. Perhaps more worrying, austerity advocates are winning the political battle in countries where government debt is low. There would be few better examples than Australia, which promoters of smaller government claim is facing a budget emergency (rather than just a persistent gap between outlays and revenue) when net government debt is all of 16% of GDP. Consumers won’t be able to rescue economies either. Households are still burdened with near record debts as a percentage of GDP and, come a shock, will own plunging housing assets.

What hope then for the world if a thunderbolt materialises? Most likely this. Policymakers the developed world over know they are at the limits of their power. They must have thought of possible remedies if something bad happens. If not, they have proved they can whip up palliatives if economies and banking systems shudder. The years after the global financial crisis struck ushered in unprecedented amounts of quantitative easing and emergency lending to banks under central-bank lender-of-last-resort facilities and massive fiscal stimulus. The era produced soothers such as zero interest rates and the invention of negative interest rates, which Sweden introduced in 2009 followed by Denmark in 2012 and the ECB this year. Central banks entered into bilateral currency swaps with the Fed to ensure enough US dollars to support banks in their spheres. Other central-bank tonics were so-called forward guidance to soothe any concerns about rate increases, ECB repurchase agreements designed to shove massive amounts of money at banks, Fed purchases of mortgage-backed securities to help revive housing, Fed lending facilities for borrowers and investors in crucial credit markets and cunning bluffs such as timely pledges by policymakers to do “whatever it takes” to save this and that, as the ECB did for the euro. These cures may not be enough if strife hits again but they give hope that policymakers have the inventiveness to limit the damage in the unlikely event that a threat materialises.

Financial information comes from Bloomberg unless stated otherwise.

 by Michael Collins, Investment Commentator at Fidelity

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Shinzo Abe’s “third arrow” radical plan to revive Japan’s economy.

Japan’s parliament in June began debating legislation that would allow for the country’s first casinos. Whatever the merits casinos are as tourist attractions as the bill’s backers claim versus the social ills that opponents allege will flow from their opening, they form part of the so-called third arrow, or economic reform part, of Prime Minister Shinzo Abe’s radical plan to revive Japan’s economy.

Other measures are more standard fare in a package of economic reforms that was announced in June by Abe, who started his second term as prime minister in December 2012. They include changes for the labour market, cuts to company taxes, plans to enter into more trade agreements to open up sectors such as agriculture, special zones where red tape is reduced and changes that allow for economies of scale in the ownership of farm lands.

The third arrow could well be the most revolutionary in terms of how it could change Japanese society and the economy for years, bearing in mind that it can include (and exclude) any of the proposed regulatory changes or economic reforms that are often announced ad hoc. The first two arrows of Abenomics are fiscal stimulus, which is now being reduced, and further loosening of monetary policy – a radical change in itself because it involves central-bank asset purchases that aim to double the monetary base within two years to turn deflation into inflation and achieve consistent GDP growth per capita.

The Abenomics experiment was begun in May last year to resuscitate the economy of a politically stable country beset by two decades of stop-start growth, a decade or so of deflation, the world’s biggest pile of government debt, falling real wages and a shrinking and aging population. The results, so far, are promising for an economy that Bloomberg estimates is 3.5% smaller than when Abe first came to power in September 2006. (He lasted two years.) The economy has expanded for five straight quarters and generated inflation. Investment, production and business confidence have improved and a lower yen is helping exporters. Readings of these measures, however, are not improving enough to lift Japan’s long-term growth projections.

One big challenge for the economy now is that, in an effort to tackle its debt, the government boosted the sales tax by 3 percentage points to 8% on April 1 this year. The resulting drop in consumer spending is expected to shrink the economy over the second quarter. (The tax rise boosted core consumer inflation to a 23-year high of 3.2% in the 12 months to April this year. Core consumer prices are rising at an estimated 1.3% pace when tax effects are excluded.) This means the vague third arrow has taken on greater significance as a means for reviving Japan’s economic future, particularly as Tokyo wants to become a stronger regional economic and political counterweight to China.

Shadowy arrow

The reforms announced in June were generally vague. The government, however, was most specific in saying that it wants to reduce the corporate tax rate from 35.6% to below 30%, where Australia’s rate sits. It is still to outline, however, how it will replace the lost revenue to stop adding to the government’s gross debt that amounts to about 240% of GDP.

The more-abstract announcements cover tougher corporate governance rules, including measures to untangle crossholdings among companies, to boost shareholder returns. They embrace enhanced ability for super funds to buy equities. Among others are changes to farming that allow for the consolidation of small farms and proposals to end utility monopolies to make the energy industry more efficient. Proposals for the labour market could be among the most contentious because they comprise proposals to allow more immigrants in a monocultural and homogenous society, tax changes to encourage higher female participation and steps to boost their numbers at executive level (which might be counterproductive to the government’s hopes to boost the birth rate) and more flexible labour laws. “In my growth strategy, there are neither taboos nor sacred cows,” Abe said in a televised address on June 24.[1]

Abe’s government needs to prove it can turn announcements into regulatory and legal achievements. The vested interests Abe confronts are significant. The severity of the challenges facing Japan may well give him the best-possible environment to succeed.

The fate of the legislation covering casinos may well provide a gauge as to whether or not Abe can overcome vested interests. For among the opponents of Las Vegas-styled and owned casinos are the Japanese businesses that operate various forms of legal gambling, from lotteries and gaming machines to sports betting, who fear foreign competition more than they are troubled by any social ills that might come with casinos.

Financial information comes from various media sources including The Wall Street Journal and Bloomberg.

[1] The New York Times. “Shinzo Abe’s bid to shake up corporate Japan.” 24 June 2014. http://www.nytimes.com/2014/06/25/business/international/shinzo-abes-bid-to-shake-up-corporate-japan.html?hpw&action=click&pgtype=Homepage&version=HpHedThumbWell&module=well-region&region=bottom-well&WT.nav=bottom-well&_r=0

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Anecdotal evidence suggests that smaller retailers are finding that consumers have become tightfisted.

Australia’s economy pleasantly surprised most analysts when it grew at its fastest pace in two years over the March quarter, to sustain an expansion that dates to the last quarter of 1991.[1]

Increased export sales, more household spending and greater investment in dwellings drove an economic expansion of 1.1% in the March quarter, a report in June showed. Over the 12 months to March this year, Australia’s economy expanded 3.5%, a respectable pace at any time.[2]

The spurt in exports came largely from the mining sector even though the prices of some materials such as iron ore have dropped on lower demand from China. Mining exports are rising because all the investment in the mining sector over the past decade expanded production enough to compensate for falling prices. Low interest rates explain the increases in housing investment and consumer spending.

The Reserve Bank of Australia looks set to hold the cash rate at a record low 2.5% for a while yet as inflation appears tame. The boost in mining capacity, including the onset of sales from new LNG plants, points to higher export sales. This means these two favourable conditions will be in place to help the economy expand in coming quarters. Further help for the economy is that unemployment is still low, holding at 5.8% in May, which is not far off levels regarded as full-employment. Rising housing prices and ever-climbing stock markets are making people feel wealthier. The economic news from the rest of the world is largely the same as it was at the start of the year. What could go wrong?

Well, something has. Retailers such as Pacific Brands, the maker of Bonds clothing and Sheridan bed linen, the Reject Shop, which operates discount stores, and Super Retail, which owns leisure specialty stores such as Rebel, in June issued warnings that sales have dropped so much in recent weeks that their earnings will be hit. It’s not just the big companies that are complaining. Anecdotal evidence suggests that smaller retailers around the country are finding that consumers have become tightfisted.

Some retailers are citing warmer-than-usual weather on the east coast for their predicament. (The way life works we don’t tend to hear from the retailers that benefited from the hotter May.) But many, if not nearly all, of the stressed retailers are blaming something else; the federal government budget brought down in May.

The mixture of touted spending cuts, tax increases, mooted charges for visiting a doctor and possibly higher tertiary education fees, the political brawl over fairness, inequality, allegations of broken promises and a budget emergency seems to have spooked people.

Other evidence that the budget made people jumpy was a large plunge in the consumer confidence pulse that is taken each month by Westpac Banking and the Melbourne Institute. The index they compile by surveying people fell 6.8% in May from April to 92.9, the lowest since August 2011 where 100 is the neutral level. Bill Evans, Westpac’s chief economist, said the people’s responses to the questionnaire were “clearly indicating an unfavourable response to the recent federal budget”.[3] Ominously, there was no rebound in June, even if the index did edge up to 0.2%, for June’s result still leaves the index floundering 6.6% lower than April’s level and 15.6% below the post-election high in November last year.[4]

The Reserve Bank added to concerns about declining consumer demand when it said in June that “growth of the nominal value of sales had slowed over the three months to April, and the bank’s retail liaison suggested that growth had moderated further in May.”[5] (Retail liaison is the central bank’s jargon for its discussions with retailers.)

The budget, as a document for managing the economy over the next 12 months, carried to punch against economic growth because few of its higher charges, increased taxes and spending cuts take immediate effect. But the thought of likely future stress on household budgets has dampened people’s willingness to spend as robustly as before.

Consumer sentiment has plunged for a variety of reasons in the past without damaging the economy. People can still spend when they are worried about the outlook or move on from these doubts and confidence bounces back. Retail sales are only a partial guide to consumer spending as they only amounts to about 20% to 25% of GDP. Perhaps household spending outside the retail sector – on items from school fees to medical bills that comprise about 25% to 30% of output – has picked up. (Total household consumption sits at about 50% of GDP. The breakdown between sales at retail stores and other consumer spending is murky.)

The danger is, though, that if retail spending is sluggish and consumer sentiment is poor then economic growth will be hampered. For it’s hard for exports, business investment or government spending to compensate for the shortfall in consumer spending.

It’s a while off before we find out how the economy performed for the just-ended June quarter. The verdict on the evidence so far mustered is unlikely to pleasantly surprise.

Financial information comes from Bloomberg unless stated otherwise.

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Michael Collins

Amid all the threats and counter-threats between Russia and the west over recent events in Ukraine was a warning by Kremlin aide Sergei Glazyev that Moscow might orchestrate the end of the US dollar’s role as the world’s foremost reserve currency.[1]

While Glazyev’s threat was risible, he is one of the many to give voice to a likely shift in the international payments system in coming years. This is the mooted decline of the US dollar’s premier reserve status as the yuan becomes a reserve currency, which is one that is widely held by governments and institutions among their foreign-exchange reserves because it is seen as a store of value. At the moment, about 61% of the world’s official forex reserves are held in US dollars, while 24% are held in euros.[2] Other reserve currencies are the UK pound and the yen (each 4% of total reserves), the Australian and Canadian dollars (2% each) and the Swiss franc (0.3%). The currency officially known as the renminbi – the primary unit is the yuan much like the pound is for sterling – barely figures.

China’s significance as the world’s second-largest economy and the biggest global trader and official moves to “internationalise” the use of the yuan – essentially when it is used between non-residents – and to liberalise China’s financial system fan talk that before too long the yuan will become a reserve currency. After all, China is the only one of the world’s six largest economies not to have a currency with such status. So preordained seems the yuan’s ascension that European Central Bank board member Yves Mersch said in February that the yuan might one day “challenge” the US dollar’s prominence as the world’s foremost currency.[3]

Much needs to happen before the banknotes that feature Mao Zedong attain reserve standing, let alone shove aside the US dollar. The yuan is not market determined – the currency is set daily and trades within a daily 2% band – and the government restricts capital flows, two breaches of prerequisites for reserve status. Other missing essentials are deep capital markets and sound political and macroeconomic settings, for investors need to have faith in yuan-denominated securities if they are to hold reserves in yuan. Wider use of the yuan and, by definition, the freeing up of capital flows in and out of China, could come with turmoil that retards the currency’s ascension – after all, in the words of Philip Lowe, deputy governor of the Reserve Bank of Australia, “there is no historical precedent for an economy of China’s size and relative stage of development integrating itself into a global financial system”.[4] But events are moving towards the yuan gaining reserve stature as the Chinese are relaxing controls on the currency and capital flows.

If China’s financial liberalisation is extensive enough to promote the yuan to reserve heights, China will benefit in many ways. Reserve status will make global trade and financing cheaper for Chinese businesses. It will create better foundations for China’s macroeconomic management, deliver more diversified portfolios for Chinese and foreign investors and generate better risk-management (hedging) products and markets for investors. Importantly, when judging the motivation of China’s leaders, it will bolster the country’s international political power.

The gap

The title of being the world’s foremost reserve currency is rarely passed on. The last handover was from the UK pound to the US dollar in the decades after World War 1, a shift that only became official in the post-World War II Bretton Woods system. But there is usually room for other currencies to reach reserve status and, by default, diminish the prominence of the incumbents. Now is such a time.

US Congress has done more damage to the US dollar’s reserve allure than Moscow could ever do by, twice in the past three years, taking the country to the brink of default during negotiations to raise the debt ceiling. Investors and officials in other countries were aghast that infighting in Washington put at risk the US$5.8 trillion of US Treasuries they own so they are looking to diversify their holdings into other currencies. (China is the largest US creditor holding US$1.3 trillion of US government bonds, held mainly as foreign-exchange reserves.) The euro’s drawback is that no one can guarantee such a structurally flawed currency will survive.

Even before the debt showdowns in the US, the Chinese were undermining the US dollar’s reserve role. Chinese officials were panicked when, during the credit crunch of 2008, Chinese companies struggled to borrow scarce US dollars. The People’s Bank of China was forced to make the yuan available through currency swaps with other central banks, agreements that now number about 20 (including one with the RBA). Soon after that trauma, Zhou Xiaochuan, the head of the central People’s Bank of China, blamed the US dollar’s dominance as a reserve currency as the root cause of the global imbalance that triggered the crisis because it led to perennial US current-account deficits.[5] Thus Xiaochuan in March 2009 called for the use of IMF special drawing rights, which are based on the value of the US dollar, euro, UK pound and yen, as a global reserve currency as a way to diminish the unsettling role of the greenback.[6]

Booming bonds

Even if Xiaochuan’s speech was of little help, the yuan in recent years has advanced its ability to achieve reserve status. The first step in this process was for the yuan to become widely used in trading and investment. The country’s export prowess has led to the yuan’s elevation to a trading currency while the government is helping it accomplish a bigger role in investing.

The yuan’s use in commerce is spreading because Chinese companies offer discounts when trading is settled in their currency. Accordingly, the yuan in 2013 overtook the euro as the world’s second-most used currency in traditional trade finance. The Belgium-based Society for Worldwide Interbank Financial Telecommunication said the yuan had an 8.7% share of letters of credit and collections in October of that year, compared with 6.6% for the euro.[7] While well short of the US dollar’s 81% share, the yuan’s share had jumped from 1.9% only 20 months earlier – and zero if you go back to 2009 when the first trade was settled in yuan over the Hong Kong border. HSBC estimates that about 25% of China’s trade is now settled in yuan and this portion could reach one third by next year.[8]

China’s trade performance promotes the yuan’s use in investment and the government is doing its best to capitalise on this trend by nurturing China’s financial markets. Among other steps, officials have relaxed controls on foreign institutional investors buying Chinese securities, eased restrictions on interest rates and the exchange rate, allowed capital to flow freely into and out of the just-launched Shanghai Free Trade Zone and are trying to develop China’s money and bond markets. The latter is meeting with some success. International companies are happy to sell bonds denominated in yuan for their China-related financing and risk-management needs. Global investors are keen buyers because these securities offer attractive yields and the yuan has been viewed as a currency that only rises – which it did until recently, anyway. HSBC estimates that the amount of bonds denominated in yuan sold outside China has doubled each year since 2008 and the pool of such assets, which includes deposits, bonds and bank certificates of deposits, now totals 1.8 trillion yuan (A$315 billion).[9]

Another promising sign of the yuan’s wider use in investing is that there are now four “offshore” yuan trading centres; namely Hong Kong, London, Singapore (the largest)[10] and Taiwan – and Sydney could be one soon. An official yuan “trading centre” gives Chinese and other businesses the ability to convert yuan directly into other currencies via an official clearing house rather than pay the higher transaction costs of swapping into US dollars as an intermediate step. Less encouraging signs are that the ability to hedge the exchange rate risk of the yuan is still limited as such markets are underdeveloped and that the market for yuan-denominated equities sold outside China is still a fledging one.

The Brookings Institute of the US names five factors that determine the speed with which a currency attains reserve status.[11] The first is the size of its economy and China’s easily passes on this score. China is making progress on opening its capital account, adopting a flexible exchange rate and deepening its capital markets, key determinants two, three and four. It’s the fifth factor that could prove problematic even though China’s has met this hurdle in recent years. This is that investors must be confident that authorities will achieve sound macroeconomic outcomes such as tame inflation, steady growth and sustainable debt levels before they will invest in a country’s financial assets (and thereby demand the currency). China’s wobbly financial system could undermine confidence in China’s economy in coming years.

A more long-term challenge for investors is that China’s political risks are bigger and different from those emanating from the liberal western democracies that boast the other reserve currencies. Financial markets depend on the rule of law for their smooth operation. China’s government is one-party dictatorship so, by definition, rule of law is absent, as is proper corporate governance. It will be harder for Beijing to convince investors that the People’s Bank of China is an “independent” central bank in the way they perceive the Federal Reserve and RBA to be. These flaws could give other governments and official bodies pause before investing too much in yuan-denominated reserves.

It is unlikely that the US dollar will soon give way to the yuan as the world’s foremost reserve currency. Chinese policymakers will be careful to make sure liberalising interest rates, the capital account and the exchange rate don’t get ahead of domestic conditions – the removal, say, of ceilings on interest rates would disrupt China’s state companies and banks that are a large part of the economy. Who knows when the yuan will be market set, when capital flows will be fully convertible or when Chinese government and corporate bonds will be readily available and easily traded. But at the very least, policymakers and investors everywhere should prepare for a world where the yuan will play a mightier role.

by Michael Collins, Investment Commentator at Fidelity

Financial information comes from Bloomberg unless stated otherwise.

The post The yuan’s rise to reserve-currency status appeared first on AdviserVoice.

Michael Collins

Search around Europe and encouraging signs emerge amid the immense unemployment and political agitation. The eurozone economy expanded 0.3% in the three months to December, to mark three straight quarters of growth after six of shrinking.

Confidence and business indicators are rising – the Markit purchasing managers index is close to a three-year high. The combined fiscal deficits of eurozone governments in 2013 fell to the target 3% of GDP for the first time since 2008. The 18-country bloc is recording its biggest monthly current-account surpluses in five years. Officials have made progress on a banking union. Greece in April sold its first government bonds since its default two years ago, at the lower-than-expected effective rate of 5% compared with 30% in 2012, while Portugal’s first bond sale since its rescue in 2011 was oversubscribed too. Sovereign yields for the bailout countries are at their lowest since 2005. European government and corporate debt is trading at its narrowest spread over benchmark German equivalents since 2007. Moody’s Investors Service reports that credit rating upgrades for the March quarter outdid downgrades for the first time in more than six years. Equities have jumped on the promising signs – the STOXX Europe 600 Index has rallied more than 26% since mid-2012.[1]

July of two years ago is taken as the point when confidence in Europe improved for that’s when the European Central Bank pledged to do “whatever it takes” to save the euro. These words instilled a belief that the euro will survive a crisis in its fifth year. But this optimism has spawned a fresh peril. This is the more-than-15% rally in the euro over the past 22 months to just below 1.40 to the US dollar – 1.3934 on March 18 is the euro’s post-crisis high compared with 1.2061 on 24 July 2012. The surge in the currency creates two dangers. The first is that it undoes the region’s improved trade competitiveness. More alarming, the mighty euro is fanning deflationary forces as it lowers the price of imports. Deflation is a poison for such an indebted region and could place the single currency under threat again.

European policymakers have remedies at hand; above all, quantitative easing by the ECB. Ideology and practical limitations, however, make this cure problematic. The questions for investors are whether the ECB will launch an asset-buying program in time and whether one would prove effective in rekindling economic growth and staving off deflation.

The bloc’s problems are far bigger than just a strong euro, of course. The economic crisis has spawned a nationalistic revival that makes it harder to achieve the political union a common currency needs to survive. A generation of young is being lost to joblessness. The worsening debt-to-GDP ratios of many countries could spell default sooner than later without deflation – “lowflation”,[2] as the IMF calls it, is as toxic for a region where net government debt stands at 96% of GDP.[3] Austerity is a bigger cause of disinflation than the strong euro anyway, for in a fixed-exchange-rate regime lowering wages and other costs is the only way to regain competitiveness within the bloc. A drop in global energy, commodities and food prices is putting downward pressure on inflation, so the villain’s not just the rising euro. Some people argue that, while eurozone inflation is too low, the ECB will still meet its inflation goal of keeping price rises to below, but close to, 2% over the medium term.[4] The Federal Reserve could remove much upward pressure on euro by accelerating the end of its asset-buying, which would boost US interest rates and thus the US dollar. These factors, though, don’t mitigate against the facts that the high euro limits Europe’s ability to trade its way out of the doldrums and could be the final shock that enshrines deflation. It shows the conundrums, or even the hopelessness, facing eurozone policymakers – even their successes generate a bigger risk of failure.

Upwards and backwards

The euro is rising for a number of reasons that show no sign of abating. One cause is that the eurozone’s inflation is below that of its trading partners. Eurozone prices only rose 0.7% in the 12 months to April (after being as low as 0.5% in the 12 months to March) while the latest readings show annual inflation in Japan, the UK and the US was 1.6%, 1.6% and 1.5% respectively and is higher in most other countries. Docile inflation supports a currency because, in theory, exchange rates should adjust for inflation over the long term to keep the real costs of goods steady across countries.

A second force is the eurozone’s improved trade performance. Austerity has crippled domestic demand in bailed-out Europe, and thus fewer imports are flowing in. At the same time, austerity has reduced labour and other costs, making exports more competitive. The current-account surplus of the eurozone stood at 2.9% of GDP last year, compared with a deficit at 0.7% of output in 2007.[5] Trade performance is another fundamental determinant of exchange rates for it governs the balance of demand for a currency between importers and exporters.

The third reason behind the strong euro is that Europe’s interest rates are higher than elsewhere. Lingering uncertainties about peripheral countries mean their bonds are trading at premium yields over equivalents in Japan, the UK and the US where central-bank asset buying has lowered interest rates. This promotes the so-called carry trade where investors borrow in the currency of a country with low interest rates to invest in higher-yielding euro-denominated securities (while hoping exchange rates don’t move against them). A fourth reason propping up the euro is that European banks are understood to be selling foreign assets and converting the proceeds to euros to bolster their balance sheets to meet capital ratios.

On top of these reasons sits the confidence that the ECB has rescued the euro. This optimism is inspiring the bond buying that has driven down yields on European government and corporate debt from their crisis highs. It is encouraging other investment flows into the eurozone, even into the bailed-out countries. Other sources of demand for European securities and thus the euro are investors fleeing emerging markets, central banks diversifying their foreign-exchange reserves away from US-dollar denominated assets and investors pouncing on cheap euro-priced assets. Foreigners drive up the euro when they buy euro-denominated stocks, debt and other securities because they need to convert their currency into euros to take hold of the assets.

Many European officials have voiced concern about the high exchange rate. Jean-Claude Juncker, a leading candidate to be EC president this year, warned as he stopped presiding over meetings of European finance ministers in January 2013 that the euro was “dangerously high” when it was 1.34 to the US dollar.[6] More recently in March, Herman Van Rompuy, the president of the European Council, said that the euro is “too strong for our exporters”.[7] In April, Belgian Finance Minister Koen Geens warned the strong currency “creates a risk of deflation”.[8] In central-bank jargon, ECB President Mario Draghi echoed the same concern when he spoke of the euro “becoming increasing relevant in our assessment of price stability”,[9] which is the ECB’s only goal. (Unlike the Fed and the Reserve Bank of Australia, the ECB is not charged with fostering full employment.)

Decision time

The pressure on the ECB to haul in the euro is building. Draghi on May 8 said the high euro was “a serious cause for concern” and promised action at the ECB’s next policy-setting meeting in June when the central bank releases its next inflation forecasts. “The governing council is comfortable with acting next time,” he said, after the council just met and made no change to monetary policy.[10]

The big jolt for the euro would be if the ECB mimics the Bank of Japan, the Fed and the Bank of England by implementing a quantitative-easing program. Among other options are negative interest rates on bank deposits with the ECB to encourage banks to lend the money instead or pruning the cash rate from its record low of 0.25%.

Until now, political constraints have stopped the stateless ECB from expanding its balance sheet to buy assets. The biggest opposition has come from inflationphobic Germany (even though such programs barely budge inflation, for quantitative easing is not printing money, which falls under fiscal policy even if it requires the help of a central bank). Since the eurozone crisis erupted in 2009, two Germany central bankers have quit the ECB, in part due to their hostility towards asset buying in forms that fall short of quantitative easing. In 2011, Alex Weber resigned as president of the Bundesbank, a role that sits on the ECB’s policy-setting board, and Jüergen Stark quit as ECB chief economist because they said the ECB was acting outside its mandate when buying small amounts of sovereign debt of struggling countries on the secondary market to drive down interest rates. These purchases weren’t under the guise of a quantitative-easing program because they were sterilised – the ECB took counteracting steps to keep the money supply steady, whereas quantitative easing expands the monetary base.

Weber’s successor as head of the Bundesbank, Jens Weidmann, has spoken out against many of the ECB’s attempts to stabilise the eurozone. He opposed the ECB’s powers to buy unlimited amounts of bonds under its yet-to-be-implemented-or-even-detailed Outright Monetary Transactions program, the scheme that enforces Draghi’s promise to save the euro, a program under which bond buying of deadbeat sovereigns would be sterilised. But as threats shift so too is Germany’s thinking. The danger of deflation, even in Germany, prompted Weidmann on March 25 to concede that quantitative easing “isn’t generally out of the question” when considering the legal restrictions on the ECB.[11] (Five of the 18 euro-using countries suffered deflation in the year to March.)After the ECB policy-setting meeting on April 3, Draghi announced that board members were “unanimous” in backing “unconventional instruments within its mandate” such as quantitative easing to keep deflation at bay.[12] The extent and form of any such asset-buying are open questions, though, as is what would prompt the ECB to sanction such a step.

The euro has nudged up a touch amid all the ECB comments about quantitative easing because forex traders are dismissing Draghi’s talk as just that. At the same time, bond investors are pricing in a massive ECB buying spree (a trillion euros) and will be disheartened if political or any other constraints limit any ECB purchases. Hardliners in the stronger countries oppose measures that take pressure off bailed-out countries for they claim they will go slow on reforms that boost competitiveness. Nationalistic forces will oppose handing more power to a central authority such as the ECB. Countries, especially Germany, could face legal restrictions if their central banks take part in any quantitative easing by the ECB. Any ECB quantitative easing will probably be far more limited than, say, the Fed’s three bursts, which have quadrupled the US central bank’s balance sheet to US$4 trillion (A$4.3 trillion). If the ECB undertakes quantitative easing, it has debt from 18 governments to choose from, another political headache. The weaker countries with deflation have less liquid debt markets, which makes it trickier for the ECB to act where it can do the most good. Stronger-but-still-challenged countries such as France have more muscle to ensure their bonds are targeted instead. The ECB is understood to be keen to buy private assets such as asset-backed securities because such purchases would have greater chance of boosting lending to businesses in rescued countries. But such markets are illiquid and small, making pricing problematic and reducing any economy-wide effects. A side effect of quantitative easing would be to boost the value of bonds on bank balance sheets, possibly distorting the ECB’s stress tests on banks it will soon supervise. Emerging countries may well accuse the ECB of engaging in currency wars.

The ECB board members and national governments could easily fall out over these issues and no program is launched. On the other hand, if eurozone inflation readings head up the ECB will happily do nothing. After all, even in the middle of a jobless crisis, why do anything when under the cursed euro even achievements proved jinxed?

by Michael Collins, Investment Commentator at Fidelity

————-

Financial information comes from Bloomberg unless stated otherwise.

The post The latest threat to the euro? appeared first on AdviserVoice.

Dominic Rossi

It has been a solid start for US equities after a strong 2013. Their resilience has been particularly impressive given investors had ample opportunity to take fright.

Despite much uncertainty over the crisis in Ukraine and the fact that US economic readings were weak (largely due to bad weather), equity investors shrugged off these issues. It was striking how resilient equities proved to be and how contained volatility stayed during this period.

Equity-market volatility is being anchored at low levels by confidence in the positive structural outlook for the US economy. When implied volatility (as shown in the Chicago Board of Exchange’s Volatility Index or VIX) falls below 20 (its long-term average since 1990), we have a favourable environment that allows valuations to expand. Lower volatility was a pre-requisite for the rerating in US equities that we saw in 2013 (since when volatility has averaged 14.3). While many investors became accustomed to elevated volatility through 2008 to 2012, it looks like volatility can stay low for a sustained period, much as it did in the 1990s. Investors should be wary of looking only at the recent past.

In terms of what might trigger volatility, the interest-rate cycle has become the key focus. US Federal Reserve President Janet Yellen recently let slip at a media conference the phrase “six months” in response to how soon the interest-rate cycle could start after tapering is completed. While there was a small spike in volatility and equities fell on the news, there was no reaction from US 10-year Treasuries, indicating the lack of concern among bond investors about inflation risk. Inflation is benign with little prospect of pressure building. Tapering is now well understood. Yellen is doveish on the US unemployment market. We will continue to have a supportive Fed for equities.

In the US, the news is only going to get brighter – we are at an inflection point in the US economy. Yet equity investors are not fully recognising how rapidly the US economy is strengthening. The data is improving in many areas, whether it is loans data, manufacturing output, services output or consumer confidence. US economic growth is going to surprise on the upside and we will be discussing 3%-plus growth again.               The speed of the improvement in the US federal budget deficit is remarkable. Since 2009, the fiscal deficit has shrunk to around US$600 billion (A$640 billion) from US$1.5 trillion. It is not implausible that President Barack Obama will finish his term with a fiscal surplus. In which case, we are looking at a US equity market that is similar to the late 1990s (when we had the Clinton fiscal surplus), where equities should be well supported by liquidity. When a government has a surplus, domestic savings flow to the equity market, allowing valuations to rise. As a result of this supportive liquidity, we could see the so-called cult of equity return and, ultimately, certain sectors and stock markets may well become expensive.

Earnings can go higher

In the US market, we have an unusual situation in earnings expectations. Usually, we start the year with high and unrealistic earnings forecasts that have to be revised down. The opposite is the case this year and we are likely to have a strong earnings season versus subdued expectations.

Beyond that, it is prudent to consider the standard counter-argument to the buy case for the US, which has lately become commonplace. This argument points out that the US is on a price-earnings ratio of 16 times yet corporate profitability is at record highs. And if we cyclically adjust for peak profits, then the price-earnings ratio is 22 times. Given that we are approaching an interest-rate tightening cycle, the argument is that this makes the US market a sell.

This is naïve. Profit margins may well be at record highs, but they can move higher. The distribution of profits between capital and labour in the US is going through a fundamental shift. It’s hard to see why margins need to mean revert; for this to happen, labour’s share of profits would have to move higher. Unless we go back to highly unionised workforces, which is unlikely, profits are going to remain at high levels.

There are a number of reasons why profit margins can stay high, such as the globalisation of labour forces, less organisation of labour, technological change and the ability of markets to press companies to focus on profit margins in a way that just didn’t happen 30 years ago. Clearly, if labour’s share of profits were to fall further, we could expect to see some political pressure. Overall, however, the outlook for corporate earnings remains favourable. Combined with healthy liquidity, these two drivers should sustain a multi-year bull market in US equities.

The US equity market is more likely than not to break out strongly on the upside from its current period of consolidation. With compressed yields on US-dollar- and euro-denominated credit, equities will look attractive versus debt as earnings come through. The danger could well be that US equities have a too-strong rather than too-weak a year, given the positive outlook for both liquidity and earnings.  It is evident that some investors have been left traumatised by the bear market in equities and are still fearful. However, in my view, we are in the midst of a bull market and in a bull market you buy the dips. In this light, if we get a mid-cycle correction based on the expected onset of the interest-rate tightening cycle in 2015, then this would be a buying opportunity. I believe the S&P 500 could move to 2,000 to 2,300 from its finish of 1,878.5 on May 9.

Volatility is anchored again like it was for much of the 1990s
CBOE Volatility Index (VIX) since 1990

Source: DataStream, CBOE Volatility Index. 30 March 2014

by Dominic Rossi, CIO, Equities at Fidelity

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Financial information comes from Bloomberg unless stated otherwise.

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EU elections to impact EU economy.

Imagine if fringe political parties of the left and right were gaining sufficient support in different Australian states to win enough seats at a federal election to destabilise the House of Representatives. Imagine that these parties disagree on many social and economic issues. But on one issue they are settled: Australia’s federation must be unwound, even disbanded.

Luckily for Australia, this scenario is fanciful right now. The European Union, however, is not so fortunate. European parliamentary elections are scheduled from May 22 to 25 and opinion polls suggest that a sizeable minority of anti-elite populists will be elected. Amid their differences, these Tea Party-like members of the European Parliament or MEPs will have one common purpose: to sabotage Europe’s loose federation.

Havoc would result if the Europe’s parliament were to fall under the control of the anti-EU populist lot. Such a group could block the EU’s budget and legislation. It could refuse to validate international treaties. Crucially, it could “reject” the European Commission, which means that it could strip Europe’s bureaucracy of its political legitimacy.

Polls show that nowhere near enough anti-EU lawmakers will be elected to quickly dismantle Europe’s integration of recent decades. Europe’s political institutions (including the EU) have proved resilient and malleable enough to deal with the challenges thrown at them so far by the euro crisis and that counts for a lot with many voters. That’s largely the extent the good news, however. The same polls show that anti-EU MEPs could gain one-third of the votes and a sizeable minority of EU-sceptic MEPs will be elected to the European Parliament. While the number of seats they win will likely be lower than the percentage of votes they attract, these anti-EU MEPs will number enough to hinder a closer embrace among the EU’s 28 members. The pity is that Europe needs greater jelling if the 18 members of the eurozone are to surmount a crisis bedeviled by the fact that they share a currency without political union. At the very least, the election of a swag of anti-EU MEPs will place nationalists as the centre of European politics and clarify that Europe’s financial crisis has morphed into a political crisis.

The European Parliament is the only directly elected arm of the European political project, that, because it has formed over the past 60 years without proper voter assent, has always lacked political legitimacy (its so-called “democratic deficit”). Since 1979, elections have been held every five years for an assembly that gained more power in 2009 when it was granted shared budgetary powers. As part of Europe’s bicameral (two-step) legislative process, the parliament shares this budget and other legislative powers with the Council of the European Union, which gathers representatives of the EU member states. MEPs, however, generally can’t initiate legislation – they only get to vote on what the executive European Commission proposes.

Seats within the parliament are split between countries roughly on population size – Germany has 99 seats while Cyprus, Estonia, Luxembourg and Malta get six each – but MEPs sit in the parliament according to their political bent, not their nationality. After the 2009 poll, the 736 MEPs formed seven groups including one for the 27 non-attached and one that is eurosceptic. The biggest two were the 265-strong Group of the European People’s Party (Christian Democrats) and European Democrats and the 184-strong Group of the Party of European Socialists. The 27-strong Europe of Freedom and Democracy Group is a eurosceptic bloc. It consists of 10 political parties including Nigel Farage’s UK Independence Party.

The elites’ nemesis

The murky structure and lack of daily relevance of the European Parliament engenders it vast apathy among the EU’s 500 million citizens, of whom about 375 million are eligible to vote in May’s poll for 766 MEPs. Voters care more about who runs their country rather than who sits in Strasbourg, France, where the European Parliament is centred. Participation rates in EU elections have dropped over the seven EU elections, sliding to a record low 43% in 2009 compared with 62% in 1979 when people from just nine countries voted.[1] Germany’s participation rate has dropped from 68% to 43% over these three decades, so the fading interest is not just because voters in the other 19 countries are apathetic.

Europe’s problem is that the continent’s crisis has motivated a segment of the population to vote in May. They are disgruntled nationalists vulnerable to populism who want to diminish the influence on their lives of “Brussels”. This is the term that captures for them the elitist, undemocratic and borderless project that is the EU, which has failed at one of its core promises – to create prosperity. (Preventing more world wars was another.) For Brussels is where most of Europe’s centralised bodies reside, including some of the parliamentary functions that are split between the Belgian capital, Luxembourg and Strasbourg.

High unemployment is notorious for creating a political environment ripe for populists and extremists who are talented at presenting themselves as reasonable. Europe’s record joblessness of 12% is giving rise to nationalism among the bailed-out and their donors – the former resent the austerity conditions imposed by rescue packages, the latter that they need to help those who lived beyond their means. The high unemployment is boosting the appeal of anti-elite, nationalistic candidates railing against austerity-inspired economic stagnation, the euro, crime, immigration (often shaped as a threat to the welfare state), Muslims, the Roma (gypsies), corruption among the elite, free trade, corruption within mainstream parties and the EU’s ability to trump national sovereignty and squash national identity.

It’s little wonder that heading into elections that are conducted under different proportional representative systems in each country, anti-EU fringe parties are leading, or are among the leaders, in the opinion polls in major countries. Marine Le Pen’s National Front, with its policy to return to the franc, is topping French polls, having recently done well in nationwide municipal elections. The UK Independence Party, whose popularity has forced a referendum scheduled for 2017 on whether the UK will stay in the EU, is leading there. Geert Wilders’ Party for Freedom is doing well in the Netherlands. Beppe Grillo’s Five Star Movement is prospering in Italy. Even in full-employment Austria, the anti-immigrant Freedom Party is gaining support, as are Belgium’s Flemish Interest, Denmark’s Progress Party, Greece’s Golden Dawn, the Sweden Democrats and nationalist parties in Poland, Hungary and elsewhere in eastern Europe. On the other hand, in Germany, while the anti-euro Alternative for Germany is polling in the double digits, fringe parties have little support. Strife-ridden Spain and Portugal appear free from the anti-EU curse, mainly because people trust their own governments less than Brussels.

Proven power

The capacity of anti-elitist parties to rattle Europe’s political establishment was repeatedly shown in 2013. Grillo’s Five Star Movement won the most votes of any party in Italy’s election and left the country in political limbo for two months until a fragile coalition of other parties was formed. Austria’s Freedom Party won 21% of the vote in general elections in September while the ruling two-party coalition recorded its worst-ever result.

The biggest shock of last year occurred in France in October when Le Pen’s National Front triumphed over the mainstream parties at a local council by-election in Brignoles, a small town in Provence in the south. The National Front won 54% of the vote in a second-round poll against the candidate from the mainstream centre-right (Gaulliste) Union For a Popular Movement. The candidate from President François Hollande’s Socialist party was knocked out in the first round. The National Front victory was significant because the purpose of a run-off electoral system (and impediments like thresholds) is to handicap fringe parties, yet the National Front succeeded.

That shock was magnified in February this year in Switzerland, which is not part of the EU but none the less integrated by various treaties into the 28-member union. The Swiss showed the power of populism when they approved by a margin of 0.6% a referendum to install immigration quotas against fellow Europeans even though the country’s political and business leaders opposed the measure. The ramifications for the country’s relationship with the EU are still to play out, but the result energised anti-elite groupings.

Ironically, the anti-establishment parties are forming regional alliances to help their quest against the EU, following on from the creation of the pan-continental European Alliance for Freedom party in 2010. In November, Le Pen’s National Front and Wilders’ Party for Freedom announced they would co-operate to build a continental-wide alliance to “fight this monster called Europe”, as Wilders’ put it, that “has enslaved our various peoples”, according to Le Pen.[2]

Who knows how well the anti-EU parties will do in May. The economy is not a 1930s-like disaster and so it is not stirring up the political radicalism of that era. If the fringe parties do thrive at the polls, they might fight among themselves rather than turn Europe’s parliament into a battle over the EU. But even if the anti-elite parties fail to gain enough seats to exert too much influence in Strasbourg, they are sure to do well enough at the polls to damn the prospect of further European integration by forcing mainstream parties at home to adopt more nationalistic agendas. Traditional parties are already moving closer to their populist anti-EU stances to thwart the long-term threat they pose. Governments in Austria, Belgium, France, Germany, the Netherlands and the UK, for instance, are cracking down or are thinking about restricting the free movement of people within the EU, to win back the anti-immigration protest vote.

If leaders in the advanced EU countries are pushing to repatriate power from Brussels to appease the nationalistic insurrection against the EU, it’s hard to see how the continental-wide co-operation that Europe and the euro need to thrive will emerge any time soon. After all, imagine how fraught politics would be in Australia if the Liberal and Labor parties were in favour of diffusing the power of the federal government to stymie the rise of state-based secessionist movements that are only becoming more mainstream.

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