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Post by Chief Economist Jean Ergas

1 - Today’s action

Europe continues to play waiting  game- Euro Zone still in deflation – Are we in the 1930’s? Inflationist camp  living in a by-gone world – Following events in France - Are we on the verge  of another 1968? OPEC conference – not expecting major changes

Equity markets in Europe marking  time – US investors alert on their perch!

Equity  markets in Europe are marking time while waiting for the trio of a US data  avalanche this week, the OPECE conference and the ECB meeting. US investors  shall be alert on their perch for the personal income, consumption and  savings data. With manufacturing doing a dead man’s shuffle - the customer is  king!

ECB needs to get cracking on  deflation – is this the 1930’s?

The  ECB shall have its work cut out this week, with Euro Zone consumer inflation  staging a dramatic advance to – 0.1 per cent. Consumer prices are continuing  to fall – albeit at a slower pace. This is causing havoc with regard to  capital structures – goodbye Modigliani – Miller and leading to a  re-leveraging of the economy.

Interest rates at levels not seen  since publication of “The origin of the species”!

Notwithstanding  massive monetary injections and easing of interest rates not seen from before  the publication of “The origin of the species” – prices refuse to budge. As  we have often mentioned, in the Euro Zone, we are in the post-industrial era  – with energy price increases having a more limited impact.

Those expecting inflation harking  back to a by-gone world!

The  “inflationist” camp is harking back to the global economy, pre WTO – internet  and China. The world has changed – along with unlimited supplies of labor  globalization has brought unheard of economies of scale and – if all else  fails – state financed overcapacity.

We shall not get inflation from  services – too much price transparency

Some  are looking to the service sector for a price boost – internal “organic”  inflation. We see the potential here as limited for two reasons: wages are  going nowhere and there is scant pricing power in highly transparent  commodity product domestic markets.

Who cares what Euro Zone inflation  is – 2 per cent is a rounding error!

Whether  Euro Zone inflation is 1 per cent – ½ per cent or 2 per cent is utterly  irrelevant. European companies compensated for a lack of structural  efficiency by riding the inflation wage and raising prices – in a form of  “pricing power for the utterly incompetent”. This is no longer possible.

Following events in France with  grim fascination – echoes of my youth!

We are following the events unfolding in France with something akin to grim fascination. The French government’s attempts to reform the labor system are once again floundering with key industrial constituencies on strike. Some see in this a slowing of the – albeit- timid recovery.

Little to laugh about – Is this another May 1968?

We see something more serious. A victory by the strikers, who want Soviet job-security within an allegedly market economy would sound the death-knell of real reforms in the Euro Zone. Looking farther out along the curve, these may be the storm warnings for a new cohesion by labor. Should the students join in, we may be looking at another 1968!

OPEC conference – do not see major changes!

We do not see any major changes on the horizon. Iran is still playing the Lone Ranger and price support remains contingent on attacks in the Nigerian Delta and fires in Canada. Expected increases in demand are largely dependent – excluding seasonal factors – on India being the new China.

The oil producers are taking a page from the China commodities story. We believe that visibility is low and we are flying on sight.

2 - Where are we headed?

Political risk increasing

G-7 meets but scant scope for agreement on concrete measures –austerity to the “bitter end” – Japan warns of “Eve of Destruction”- need for pro-active fiscal policy – UK and Germany say No!

Political risk increasing and expected to be “swing factor” for US monetary policy decisions – UK mood appears to be veering towards not leaving EU – will this sentiment persist? Austria does not elect anti-EU president but close victory lends boost to populists – Oil continues to firm but has difficulty staying above US Dollars 50

Investor focus on US data

Advanced economy markets move higher – US dollar rises, lending boost to export focused Euro Zone – Pound stronger on polls indicating UK to stay in EU  

Investor focus now on US internal data

With the ebbing of earnings season investor focus now looking inward – US domestic data seen as key for monetary policy – US economy increasingly seen on a “stand alone” basis – Will US consumers finally start pulling their weight? US data seen as sufficiently positive to move for central bank

Expect to see increasing divergence between US and other central banks

US central bank head confirms at end of week favorable outlook for US economy – most indicators flashing all clear – expect to move in coming months – We are seeing broader cohesion at Federal Reserve – ECB shall be meeting next week – still contending with deflationary pressures.

3 - Global survey

Advanced economy stock markets recover some brio!

Advanced economy equity markets have continued to firm, with  the US near its all-time high – as concerns over political risk, commodity prices and the resilience of the US economy commence to dissipate. Expectations at the macro level remain muted with an acceptance of lower prospective growth rates and the need to “manage decline” or at best the “new normal”.

The fundamental issues remain unresolved with investors increasingly accepting of temporary solutions centered on engineering short term cyclical upswings. Political “wiggle” room to push through structural reforms is seen as limited.

We are shifting towards “capitalism in one country”

In the light of continuing slowing global growth we are seeing a shift to “capitalism in one country” with expansion centered on the US consumer. This is highlighted by investors reacting disproportionately to consumer domestic demand data as opposed to manufacturing or even domestic capital spending.

UK and US – special relationship also extending to economic model

We are seeing increasing similarities between the US and the UK growth model. Both are characterized by a sharp fall in capital spending offset by consumer demand boosted by low interest rates and housing revaluations.

These are structurally weak recoveries – with the fall in capital investment reducing productivity growth and future wage increases.

Central banks – more hope than reality?

Central banks are still seen as the ultimate bulwark notwithstanding increased skepticism as to:

The efficacy of their measures hitherto Further possible initiatives

Need to balance attempts at low grade cyclical boost with bank solvency

Growth remains slow across the advanced economies.  A further lowering of interest rates might provide a short term “shot in the arm” to selected economies. However, this would once again place bank lending margins under pressure limiting scope for re-capitalization via retained earnings.

UK – EU referendum remains key political risk event – shall this trigger a “Congress of Vienna”?

The UK – EU referendum remains the key political risk event with the need to completely recast the European chessboard - in a manner reminiscent of the Congress of Vienna in 1815. While opinion polls indicating a resounding victory of the “remain” campaign are boosting sterling and UK stocks the business world is less sanguine about the outcome.

Currency risk hedging costs are rising rapidly as option volatility hits new records. This is leading market participants to seek to hedge their long sterling exposure via cash and derivative long Swiss Franc positions.

Watch for hit to asset prices if UK leaves EU

While this – despite the basis risk- may reduce transaction exposure, we see the major short term impact of an exit as a butchery of UK asset prices. The UK economy is now largely supported by safe haven money flows into property, seen as mitigating slowing exports and continued pressure on financial institutions.

Emerging markets caught in dual squeeze – balance sheet impacted by stronger US Dollar and revenue by slowing Chinese growth

Emerging markets have given up a substantial part of their gains as the likelihood of US interest rates rising increases and slowing global growth impacts both finished goods exports and supply chains. A stronger US Dollar shall also make repayment of US Dollar denominated debt more expensive further eroding already falling margins.

Investors accepting short cycle fiscal boost as best current outcome for China

While China remains the principal alter- ego to the US with regards to acting as a growth catalyst, we see investors accepting a short cycle stimulus boost and a holding pattern as the current best outcome. The key issues of economic reform – cleaning up of the banking bad debts and reduction of overcapacity are unlikely to be tackled in the short term.

Brazil will need to contend with transition to new political structure

We continue to see Brazil, where the context is dominated by attempts to consolidate political change as the first step to getting at “The heart of the matter” - fiscal reform – as an exception. The key for the Brazilian government shall be to prevent the real from “front running” prospective political change.  

Euro Zone – ECB still the major focus in midst of persistent deflationary pressures

As regards the Euro Zone continued deflationary pressures are steering investor attention once again towards the ECB and monetary policy. We do not see the upcoming ECB meeting as indicating a shift in strategy. The single area central bank continues to need to lift prices while not further jeopardizing a precarious banking equilibrium.

Central banks now acting like sovereign states! – Now both EU and UK seen as losers in case UK exits!

If further proof was needed that central banks are the new “third estate”, the UK EU referendum has dissipated this doubt. The ECB has started to weigh in with its own set of warnings as to the consequences of an exit. We are seeing a marked shift in thinking from the inception of the crisis, when the UK’s loss was seen as the rest of the EU’s gain.

Oil price is being supported by disruptions and hopes of long run increased demand – will this be sufficient?

As concerns oil sentiment has been lifted by in the short term, continued disruptions in Canada and Nigeria, a falling rig count in the US and increased demand prospects from the emerging markets. Prices are still well below the peaks reached in 2014 and un-economical for many producers.