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Delicate equilibrium

8 June 2018

One week after Italy’s disruptive reminder that capital markets are still quite sensitive to the wrong sort of news, equity and bond markets returned to much quieter waters. Italian bond yields remain more elevated compared to other Eurozone countries than they have for a long time and this might not change for a while.

All the more important for the Eurozone and the EU as a whole then that German chancellor Angela Merkel finally put her EU reform proposals forward in the form of a newspaper interview. Strangely, they received little international attention, even though they had been eagerly awaited ever since France’s Emmanuel Macron shared his grand vision 8 months ago.

While she somewhat bluntly rejected a debt union – which would be the natural and most stability instilling next step for the lose currency union – she did make quite detailed alternative proposals, which may be more achievable than a grand vision anyway.

Namely, the conversion of the existing European stability mechanism and fund into a European IMF in all but name. This could prove to be what it takes to make the sensitive Eurozone construct more resilient against future crises. It would provide a proper framework for the extraordinary emergency measures the ECB was forced to apply under Mario Draghi’s ‘whatever-it-takes’ leadership to avert the last Eurozone crisis, and thus prevent it from reoccurring in the first place.

Perhaps even more important in fighting the cancer of populism across Europe could be her initiative to work towards a common immigration and asylum policy, to be enforced through a joint European border force. If such a policy shift succeeded, then it would even have the potential to remove a number of highly controversial Brexit red lines.

Speaking of the dreaded Brexit, it appeared to us as though the UK moved yet further away from an actual March 2019 exit from the EU. First, Labour’s swing towards demanding the government assured ‘full access’ of the UK to the EU market, and then the government’s agreement of a back-stop plan of remaining in the customs union should it be impossible to reach a new free trade accord in time.

A BINO (‘Brexit in name only’) environment would move the potential economic cliff edge further into the future, and would therefore be preferential for the UK economy compared to a 2019 exit without a well-defined trade framework. Nevertheless, the uncertainty is increasingly a drag on the UK’s economy and the fragile balance this creates between the currency markets, UK interest rates and the property market (!) is something we are discussing this week in a separate article.

From the global political perspective, trade also remains centre stage, as the G7 heads of state gather in Canada. It will be interesting how Trump will fare in what is expected to be a hostile environment towards him, given it is the US consumers who will be hit by the imposed tariffs. Given the relative strength of the US economy at the moment, Trump’s measures may also lead to an even larger current account deficit, which we discuss in our third article this week.

If it was not for political risks, we would be looking increasingly optimistic towards the summer months. Economic data flow continues to confirm that the global economy continues to prosper, even if it is no longer doing so in quite as synchronised a manner. Europe has cooled from unsustainable boom back to a far more sustainable speed of expansion, while China remains stable and the US is now running at Europe’s speed of last year. This will result in another 0.25% rate rise by the US Fed central bank next week. The general tightening of financial conditions that this causes, together with the uncertainty and trade headwinds Trump feels obliged to introduce, could soon slow the rate of expansion there in the same way Europe slowed when the Euro strengthened.

Oil has become slightly less of a concern over the past week, because the predictable supply increase on the back of the higher prices has become evident. As a result, further oil price upside now appears capped, despite the likely fall in future supply from Iran and Venezuela.

This leaves the further global economic expansion in a delicate equilibrium between further improving business sentiment, the return of more normal (albeit tighter) monetary conditions and the risk of collateral damage from Trumplomacy.

The much predicted ‘Sell-in-May-and-go-away’ market sell off pattern has passed us by and, on the basis of the stable and measured global economic expansion, we expect a similar medium-term path for equity markets. Sadly, this may well be interspersed with bouts of volatility, as politicians grapple to establish a new world order in which the USA and China play very different roles compared to the past we have known.