Taal selectie

It Is Not Only About

Pascal Blackburne & Luc Synaeghel 2018-07-06

Trade disputes are monopolising investor and media attention, with tough talk unlikely to abate before the US mid-term elections. But what if the more serious issues for financial markets were actually mounting inflationary pressures in the US and failing political unity in Europe?

Odds are high in our view that President Trump will lose control of the US Congress in November, turning him into a lame duck for the latter half of his term. More shouting and hasty decisions – not to mention retaliatory measures by the country’s trade partners – are thus to be expected during the next four months, keeping financial markets volatile.

From a broader perspective, however, we are more concerned by the winding-up of the economic cycle and consequences of the ensuing recession. Right now, almost all major economies across the globe are experiencing above-average growth, with China an exception due to both the sheer size attained by its economy and deliberate policy measures aimed at reigning in excessive credit. That said, European growth has already passed its peak and the US only owe their still accelerating pace to the “Trump growth kicker” (fiscal stimulus and infrastructure spending).

Recent business surveys in the US demonstrate very high confidence indeed, with managements signalling, for the first time in years, that they have pricing power. Given the near full capacity and employment situation, this is not surprising and will help companies offset higher input costs (energy and wages) as well as the new trade tariffs. But it also means that US inflation data is headed higher, perhaps much higher. In turn, the Federal Reserve could push interest rates up by larger increments, forcing the government to address the (then costlier) budget deficit issue and eventually pushing the economy over the edge.

In Europe, political unity is being tested by the migration issue. In a sense, it is surprising to see such tensions climax today, some 18 months after the peak in influx. But European countries appear to have reached the point where the, now very visible, presence of migrants is causing fear within the populations. Their resulting distrust of politicians is putting democracy at risk, and an implosion of the European Union construction – for political rather than monetary reasons this time round – cannot be ruled out.

A final word on the recent OPEC meeting which, in a somewhat circumvoluted way, delivered the expected outcome. OPEC members and Russia announced their intent to increase output in order to offset the drop in (mainly) Venezuelan production – and thereby avoid a damaging price spike. Truth be said, though, there are few countries that can actually pump more oil. Besides Saudi Arabia and, with some lag due to necessary investments, Russia, US shale basins are where most of the spare oil capacity lies, but they are facing serious pipeline constraints. The fundamental supply-demand picture will thus not change in the near future, keeping the oil price strong.

Fiscal Stimulus and Trade Barriers will not Solve the US Production Problem


Chart 1: Source OECD

Why is it that Europeans do not drive US cars, and that US citizens like European and Japanese models? The short (if blunt) answer is that US companies are not so good at manufacturing industrial and consumer goods.

The US are clearly very competitive in the services spaces (e.g. IT software and financial services) and export a number of commodities (e.g. grains and oil), but they have fallen behind the curve in the manufacturing segment. And that problem cannot be solved simply by trade tariffs, nor even by a weaker currency. Rather, investment is the key – preferably financed by a large pool of domestic savings and in the earlier stages of an economic upcycle.

The investments in capacity currently undertaken by US companies, courtesy of government fiscal stimulus and infrastructure spending programs, clearly do not fit this bill. They are being financed by public or private debt – the cost of which will increase as the Federal Reserve hikes interest rates – and they are occurring very late in the cycle.

Our assumption is that US growth will peak next year, when the fiscal boost deploys its full effects, slow in 2020 and then contract in 2021 – over a year later than generally anticipated. Given that investments in capacity typically take 1-2 years to be completed, this means that companies will find themselves saddled with empty (and expensive) factories just as the cycle turns. The ensuing recession will be all the more severe and protracted.

With that in mind, we would urge investors to stay out of high yield bonds and also be particularly careful with BBB-rated bonds (i.e. those at the lower end of the investment grade spectrum). The corporate bond space as a whole is currently mispriced relative to normal default rates, with the investor hunt for yield over the past years having pushed down credit spreads far too much. Meanwhile, credit agencies have not flagged the deteriorating quality of company earnings and increasing balance sheet leverage. Tax cuts enabled a great first quarter US earnings season, masking the strain on margins coming from higher input costs and interest expense. When the economic cycle eventually turns, the combination of credit rating downgrades and evaporating market liquidity – as the herd of investors runs for the exit – will likely wreak havoc in the lower quality corporate bond market.

European Unity is Again Under Strain


Bloomberg Barclays Pan-European High Yield Average OAS.



Chart 2: Source : Bloomberg

European companies also lost their competitiveness to Asia on the production of basic goods some years ago. Unlike their US peers, however, they proceeded to invest in their productive tool, making it more specialised and technologically sophisticated. This is of course particularly true of Northern Europe countries, although Spain and Portugal are now back on the investment track too, after having adjusted the hard way (massive wage reductions).

Politics, rather than economics, are the problem in Europe today – with the migration issue highlighting once again how difficult it is to maintain unity amongst European Union members. Not that the migration wave is at its peak; that occurred 18 months ago with the massive influx of war refugees from Syria and Iraq. But among the populations of Europe, the presence of migrants has now become very visible and is causing fears, whether rational or not. They are thus increasingly inclined to vote for so-called “populist” candidates who promise a solution.

The reality is that Schengen agreements have been all but abandoned, France is very much alone in trying to secure a real centre-left coalition in the European Parliament (but not acting as it preaches when it comes to accepting migrants), German leadership is frayed, and Italy’s newly formed government could well drop some form of bombshell when it unveils its budget in October.

European unity came under severe strain during the sovereign debt crisis of 2010-2011. The reasons are different today, but the pressures equally threatening.