There is
no comfort
in the truth

Pascal Blackburne & Luc Synaeghel 2017-01-12

The economic picture is looking good as we enter 2017 – and stands to get even better in 2018. Growth is accelerating globally thanks to less austere fiscal policies and large infrastructure investments. After decades of trial and error, central banks have found the holy recipe to avoid recessions and keep inflation at a moderate level: durably low interest rates and episodic money printing.

European bank troubles are finally being addressed: Italian institutions saddled with nonperforming loans will be recapitalized by their government, never mind the already huge public debt and European Union (EU) rules. Politically, the upcoming elections across Europe are not a concern because the people can be trusted to vote wisely. Middle East tensions will fade away. And President Trump will deftly sidestep his most “stupid” campaign promises.
So goes the tale that many investors currently believe in, explaining excellent recent stock market performances and vindicating elevated earnings multiples. In truth, however, many headwinds and risks lie ahead – with the potential to abruptly turn this fairy tale into a nightmare.
Chief among dangers are large government debt and very low interest rates. It is well known that the Great Financial Crisis stemmed from excessive debt accumulation. Less discussed is the fact that the crisis was “resolved” by taking on yet more debt. Policy makers will attempt to kick the can down the road as far as possible – enabling markets to continue to neglect this time bomb – but ageing demographics and infrastructure needs will eventually force recognition. Closer to detonation, especially in Europe, are banks reeling from non-performing loans and interest rates that no longer cover loan portfolio default rates, Monte Paschi being a prime example.
With oil and commodity prices on the rise, inflation is another lurking threat. At some point, it will force a policy shift away from negative rates and quantitative easing, perhaps sooner than financial markets or even central banks expect – only making the servicing of public debt costlier.
Politically too, at lot is at stake this year. Election results in the Netherlands, France, Germany and possibly Italy could mean the end of the EU and Eurozone as we now know them, causing serious chaos in European bond markets. Trumponomics is another risk factor. While we agree that actual policies will not live up to campaign promises, even a light version will already be a serious game changer – adding fuel to an economy that is already close to full employment.
However comfortable the fairy tale, the truth is that higher (perhaps much higher) interest rates lie on the horizon. We thus prefer to enter 2017 with a prudent “wait and see” approach, focussing on protecting capital rather than running after short term gains that might never materialise. To this effect, we are reinforcing protections (short European bonds, long stock market volatility) and standing firm on our gold holdings. As regards equities, we are convinced that our investments in the energy (US shale oil producing and servicing companies) and bulk shipping sectors still offer good value, although they could also be temporarily hurt by a broad-based correction.


Before discussing the challenges of 2017 in greater detail, let us briefly turn back to 2016 and reflect on how financial markets – and our portfolios – performed. Appetite for risk was such in the final weeks of 2016 that it is difficult to remember the very shaky footing on which the year began. At the time, China was viewed as the main culprit for financial market turbulences, with the US slowdown, collapsing oil prices and middle East tensions compounding investor worries.
As the year progressed, risky assets did more than recoup their losses, particularly outside of Europe. Donald Trump’s November victory then propelled equity indices even higher – but also drove a marked step-up in bond yields (bond price correction) and the US dollar. All told, from a European investor perspective, full year portfolio returns were generally in the low single digit territory.
We are happy to report a better-than-average performance, resulting largely from three rewarding bets. First, during the February turmoil, we purchased commodity- and bank-related bonds that, albeit being investment-grade, were trading far below par value. Their subsequent price recovery was spectacular, leading us to reap handsome profits in the late summer.
We were also fortunate to see our equity investments in the disliked energy and commodity sectors deliver a very strong performance last year, in sync with the oil price recovery, more than making up for the severe cost that they had inflicted on our portfolios in late 2015. In retrospect, while we were clearly too early in making these investments, the concept of preferring business risk to valuation risk, i.e. investing in healthy companies that operate in challenging industry conditions rather than blue chips that trade at elevated earnings multiples, has been validated. While also positive, the performance of our bulk shipping holdings lagged that of their energy and commodity peers in 2016, but we remain very much convinced of their future potential. Bulk shipping is a function of infrastructure spending and commodity markets – not of the level of global trade that could indeed be penalized by protectionist tendencies.
Finally, we moved in and out of the Eurostoxx index during 2016, attempting to take advantage of the news flow-driven volatility, which also contributed positively to our full year performance.
On the negative side, we should mention our short position on the German Bund. Although there was a generalized step up in bond yields during the last weeks of the year, the correction on the German market proved lesser than elsewhere in Europe, or indeed in the US. The protective effect of this position was thus limited, leading us to now consider shifting it into a broader instrument, one that shorts European bond markets at large rather than only the German Bund.
Finally, let us mention currency effects, which can be summarized as follows: a strong US dollar strong and a weak pound sterling. This of course went hand in hand with Donald Trump winning the White House and the British people voting to exit the EU. While we held quite significant exposure to the greenback before November 8, we elected to cut exposure ahead of what looked to be a very uncertain election. We did then lift our US dollar exposure again, but not to the same extent – making for a lost opportunity (but not an outright loss).


The 2008 Great Financial Crisis arose because of excessive debt. Yet, far from tackling this structural imbalance, policy decisions taken during the past 8 years have only served to add to the debt load. Government debt has thus expanded from 62% to 105% of GDP in the US. In the UK and China, it has more than doubled (from 40% to 89% and from 25% to 57% respectively). Japan is of course the extreme case, with government debt having ballooned from 170% to 230%. As for the Eurozone, government debt stood at 65% of GDP before the crisis and has now reached 90%. Among its four largest economies, only Germany has managed to contain its debt increase (from 63% to 70%). Debt has risen from 65% to 98% in France, from 103% to 132% in Italy and from 37% to 100% in Spain. Part of this debt accumulation can be explained by bank rescues but most of it stems from social welfare spending (and alas not infrastructure investments).
Ageing demographics, with their corollary of unfunded pension promises and increasing medical care costs, as well as the need to finance more and better infrastructure, mean that this debt issue will eventually need to be addressed. How and when this happens is an open question, with 2017 quite possibly seeing policy makers attempt to defer the issue yet again.
More likely to trigger a change in investor sentiment already this year are inflationary concerns. With oil and commodity prices on the rise, inflation is gaining traction. Obvious first round effects due to oil consumption for heating and driving purposes will later be compounded by second round effects, when companies lift the prices of their goods because of costlier production (higher energy/material prices, rising wages and increasing administrative costs due to ever more regulation).
Although this danger is not imminent either, the two countries most at risk of inflationary pressures during the coming year are the US (more on page 4) and Germany. The German tabloid Bild recently titled “Give us back our interest”. Clearly, the combination of zero interest rates and near 2% inflation – soon to break that threshold simply because of oil price base effects, as the early 2016 lows are lapped – means that German consumers are losing purchasing power. Adding to upward price pressures in Germany are labour market tensions. In a politically-charged year and given near full employment conditions, it would not be surprising to see the powerful German trade unions negotiate considerable wage increases.
In turn, Germany could force the European Central Bank (ECB) to tighten monetary policy sooner than it, or indeed financial markets, currently expects – wreaking havoc on European bond markets. The ECB’s recent promise to continue its asset purchases, at a slighter reduced monthly rate of EUR 60 billion, between April and December 2017 is just that: a promise, not a commitment. Highly indebted countries with a fast ageing population (Italy, Portugal, Belgium, Spain and France to name but a few) would of course be the most exposed to a normalisation of ECB policy, standing to face much higher debt servicing costs.


Political risks are unlikely to materialize in the very near term. In Europe, the saga will only begin in March, with Dutch elections scheduled for March 15 and the triggering of Article 50 by the UK due by the end of that month. The two rounds of the French Presidential elections will then follow on April 23 and May 7, while the German elections are to take place between the end of August and the end of October. Early Italian elections are also quite possible, maybe around June, such in the anger of the population in the face of yet another non-elected Prime Minister.
If by surprise one (or more) of the current leaders in these countries comes to be replaced by a populist Euro sceptic, then we could see more countries follow the UK example – and lose ECB support. This would also create serious chaos in European bond markets, with ballooning spreads for the countries involved (especially Italy and France). Although we believe/hope that such a scenario will not materialise, it cannot be excluded. Last year, no one thought a Brexit or Trump victory possible, but both did happen.
Turning to the US, the initial weeks of 2017 should also be benign, with the newly elected President and Republican-dominated Congress seeking to give US voters and corporations some quick wins, particularly on the tax front. The unwinding of Obamacare and setting up of an infrastructure investment program will also be high on the agenda, although they are likely to take longer to implement. And chances are that “bad” policy proposals (huge tariffs on Chinese imports or the construction of a wall along the Mexican border) will be delayed, if not abandoned.
Eventually though, good news will turn sour. Stimulating an economy that is already close to full employment and in which the first signs of wage pressure are already visible is dangerous for inflation. Admittedly, the labour participation rate has some room to increase, especially if Obamacare is repealed, but that will only buy time. Adding to inflationary concerns in the US are the intended import taxes, which will make basic consumer goods more expensive at a time when energy and housing prices are also on the rise. To us, this looks like the perfect recipe for much higher inflation in the future.
The Federal Reserve’s reaction will thus be crucial. It will have to choose between fighting upcoming inflation (one if its two policy targets, alongside full employment) with higher interest rates or letting economic growth pick up speed by deliberately remaining behind the curve. This will be no easy task, particularly if President Trump refuses to see a more expensive dollar (already overvalued by more than 20%) hurt US exports.
Higher US rates would push up rates elsewhere, with bond arbitrage notably adding to the pressure on the ECB to taper (forcing the artificially high spreads between USD and EUR bonds to narrow to a more normal level). They will also strengthen the greenback further unless central banks intervene by selling dollar reserves (as the Chinese are already doing to support the yuan).
Ultimately, how 2017 turns out is very difficult to predict because of the numerous unknowns. Which is why we have such trouble understanding financial markets’ ongoing appetite for risk.