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Pascal Blackburne & Luc Synaeghel 2018-06-08

Image Credit : Carlo Botta

European political waters were supposed to be calmer this year, after the many electoral hurdles of 2017. But investors’ nerves were tested again in late May with the ousting of the Spanish Prime Minister (leaving his successor at the helm of a very fragmented parliament) and complicated negotiations with respect to the formation of a populist government in Italy.

The Italian President’s refusal of the first coalition government proposed by the Five Star Movement and the Lega is widely attributed to the fact that Eurosceptic Paolo Savona was to be Minister of Economy and Finances. What if it were really the European Central Bank (ECB) that called the “no-go”? Indeed, not only will the extra deficit created by the coalition’s promised tax cuts (ca. 5-6% of GDP) well exceed European Union (EU) rules, but the aspiring government is also said to be planning to issue mini-BOTS as a means of payment. For the unfamiliar, mini-BOTS are Treasury bills with very low nominal value, bearing no interest and that never mature. Officially, they would be confined to transactions between the Italian people and the government (tax payments and social benefits) but private businesses could also (be forced to?) accept them. Italy would de facto be introducing a parallel currency, clearly not a palatable prospect to the ECB.

Jump-starting the Italian economy is not a bad plan per se. Large tax cuts certainly make more sense in floundering Italy than they do in late-cycle US. The constraint, however, lies in the already huge debt burden. At some point, we believe that a restructuring of this debt will be necessary, perhaps in the form of the maturity extension at a zero-rate that was afforded to Greece. This may not be termed debt monetization, but it is effectively what it would amount to.

Beyond politics are… geopolitics. President Trump has just taken his protectionist measures one step further, removing the tariff exemptions previously accorded to Canada, Mexico and Europe. Retaliatory moves are expected, as well as procedures before the World Trade Organisation – itself held hostage by the systematic US blocking of nominations to fill empty seats.

On the oil market front, the OPEC is intent on avoiding a price spike that would prove counterproductive. In the face of plummeting Venezuelan output, Saudi Arabia and Russia thus recently agreed to up their own production, causing a reversal in long speculative positions and a concomitant correction in the oil price. Underlying supply-demand fundamentals nonetheless remains strong.

All told, we hold firm to our prudent and niche-oriented portfolio approach, investing in baskets of selected stocks in sectors that combine attractive prospects and still reasonable valuations, and keeping a short duration on the fixed income side. We actually took advantage of the recent turmoil to increase our short position on government bonds, German Bunds in particular. As regards currencies, our longer-term intention continues to be to reduce US dollar exposure, but the resumption of European woes justifies some procrastination – the greenback having recently proved a good hedge for Euro-based investors.

 

Weakening Europe

NCB Target

Chart 1: Eurozone National Central Bank (NCB) balances in the TARGET 2 system (in EUR billions). Source : ECB

Recent political turbulences in Southern Europe have caused renewed capital flight to the “safer” northern countries, with businesses and private persons closing bank accounts in Italy, Spain and Portugal. As a result, by virtue of the TARGET 2 Eurozone financial settlement system, German central bank claims on its southern European peers will continue to mount (the “surplus” accumulated over the past decade already exceeds 25% of Germany’s GDP – see Chart 1).

The ECB would counter that TARGET 2 is but a bookkeeping system. In effect though, should the Eurozone eventually break up, the Bundesbank would face the risk to that peripheral central banks cannot meet their liabilities. Needless to say, German monetary authorities will not want to go down the road – desired by French President Macron – of greater EU integration.

In the Far West-like world that we now live in, where treaties are no longer respected and international organisations have become lame ducks, this will only serve to squeeze Europe’s position between the US that hold the world reserve currency (so can run deficits unabashedly) and are no longer energy-dependent, China that boasts large capital surpluses, and even Japan that has a strong leadership and is a strategic US ally in Asia.

 

OPEC/Russia Continues To "Steer" The Oil Price

Late May, Saudi Arabia and Russia discussed an easing of the November 2016 cap on oil production – ahead of the formal OPEC meeting scheduled for June 22. With Venezuelan output falling rapidly and durably, and global demand continuing strong, the Brent oil price was flirting with the USD 80 level. Following these talks, and the reported decision to raise gradually production by 1 million barrels per day, the oil price took a hit (see chart 2).

brent

Chart 2: Brent oil price (in USD). Source : Bloomberg

Speculators were clearly caught wrong-footed, but our take on this agreement is not negative. Rather, we see it as a means to avoid an oil shock, which would threaten to break the global economic engine and also encourage development of large oil projects, dampening longer term prospects for the oil price.

With inventories below their 5-year average and still shrinking (less than 30 days of consumption are now covered), oil fundamentals continue to be very supportive.

Of note also regarding oil is the recent widening of the spread between WTI and Brent prices (see chart 3). Both are widely-used benchmarks for the energy commodity, the former being located in the US and the latter being located in the North Sea.

spreadbrent

Chart 3: Spread between the WTI and Brent oil price (in USD). Source : Bloomberg

The price gap between these two benchmarks is typically seen as a measure of political risk since any developments that threaten Middle-Eastern oil production tend to drive up the Brent price, without having much effect on the WTI price.

While this is no doubt occurring at present, other factors are also contributing to enlarge the WTI-Brent spread. Specifically, US oil exports – on which Congress lifted its 40-year ban a few years ago, under the Obama presidency – are being constrained by serious pipeline bottlenecks in the Permian basin and the requirement for substantial infrastructure investments (e.g. the building of new loading facilities for tankers). As much as the US would like to export more oil, to take advantage of the higher international price, they simply cannot do so for the time being. In fact, due to a lack of sufficient export capacity and ever increasing shale oil production, the US are drowning in their own oil for the moment and it could take up to two years to fix the problem. In the meantime, US oil inventories will be on the rise again