"Always make the audience suffer as much as possible.”
As 2016 draws to a close, the sensation is similar to being spectators of a Hitchcock movie. The curtains of QE stimulus slowly come off, and all of a sudden the political and social tensions that had been building up over the past eight years of crisis come to the fore, all at once. There are three main actors we see playing in 2017:
The first one is populism. We have been flagging the rise of inequality within developed countries for years, yet only a few investors cared in the past. This year, inequality has provided fertile ground to Trump, Brexit and No votes in the US, UK and Italy. Next year Europe will face four elections – in Italy, the Netherlands, France and Germany. The emergence of protest politics will mean more fiscal stimulus, protectionism (trade tariffs, curbs to migration) and rising geopolitical risks.
The second actor is fiscal stimulus. The US, UK, Japan and to a lesser extent, the Eurozone are all going to expand their fiscal spending, shifting away from austerity. In some cases, spending plans will boost the economy – like infrastructure spending in the US – which will also help to absorb some of the unemployment left over in the construction and energy sectors. In other cases, stimulus will be less effective, like tax cuts to high-income earners.
The third actor is monetary policy, whose powers are gradually fading. While central bankers have driven markets over the past eight years, the tide has turned now, as we have highlighted since the summer. For central banks the mantra is now less is more, for two reasons: they have realised that QE infinity is self-defeating in bank-centred financial systems like Europe and Japan, and they are coming under increasing pressure to normalise interest rates from savers, insurers and pension funds.
We know the cast. How will 2017: The Movie look like?
1. The Leopard (1963) – the muddle-through scenario. The US is likely to benefit from infrastructure investment and an aligned government-congress. US growth rises to over 2.5%, pushing the Fed to hike up to three times and US Treasury yields up to 3%. The Euro depreciates vs the Dollar to parity, boosting German exports and Eurozone inflation up to 1.6-1.7%. Bunds widen more than Treasuries. Le Pen, Grillo and Geert Wilders come close to winning, but they lose. However, they influence mainstream policies, adding additional spending. The UK gets a staggered Brexit deal and Greece a small debt extension. Everything must change, so that everything stays the same.
2. Reservoir Dogs (1992) – the worst case scenario. The Trump administration implements not only domestic spending, but also imposes heavy tariffs on Chinese imports and limits migration from Mexico. China retaliates with a sudden depreciation of the Yuan, which falls by over 10%, dragging down other EM currencies with it. This hurts EM sovereigns and corporates, which have heavily relied on hard-currency funding over the past years. Russia-backed Front National and Five Star Movement win elections in France and Italy, reviving Eurozone breakup fears. As a result, the Euro falls below parity with the Dollar, boosting inflation in Germany and putting even more pressure on the ECB to curb its stimulus. The UK is granted a relatively benign Brexit deal. There is lack of agreement on Greece between the IMF and Eurozone creditors. Russia continues to expand, projecting its power further across Eastern Europe. Turkey rejects its deal on migrants, adding to economic pressures in Southern Europe. The ending is not pretty: a less stable, de-globalised world with unsustainable populist policies in place. If you shoot this man, you die next.
3. The Big Lebowski (1998) – the best case scenario. Mr Trump’s foreign policy implementation comes out to be a lot more balanced than his pre-electoral speeches. Germany wakes up to the threats Europe faces by re-engineering a Juncker plan that is credible and of appropriate size, rather than the current 0.1% of GDP spent. Italy reforms its electoral law, electing a stable government. Le Pen fails in France. The UK reverses course on Brexit, accepting associate membership and agreeing to pay for access to the single market. Greece gets a serious debt restructuring/extension equal to 10% of net present value. There is a happy ending, after thinking you’re entering a world of pain.
Our base case is a combination of the first two scenarios. However, in all three, bond investors are worse off. Rising populism, fiscal expansion and fading monetary policy stimulus mean higher interest rates and inflation and higher volatility. This calls for more defensive strategies, able to monetise gains from a difficult investment environment.
In Europe, we expect economic growth to remain resilient. However, the main risk will be political, as France, Italy, the Netherlands and Germany will face rising support for populist parties at elections. We believe the ECB has set the ground for further tapering next year, especially as higher oil prices push up inflation and a weaker euro boosts German exports. We remain short core rates, and expect further widening in French government spreads as the risk of a Le Pen victory rises ahead of April’s French Presidential elections.
In the UK, we expect Brexit concerns to intensify again as the government triggers Article 50 in March and enters negotiations with the EU. Our base case is for a hard Brexit, with the UK losing EU single market access and passporting rights. This means structurally weaker Sterling, more import-led inflation and potentially deteriorating sovereign rating or a loss of reserve currency status. Gilts appear the most vulnerable to these risks.
We expect growth and inflation to accelerate in the US, supported by stronger stimulus under Trump’s administration. The Fed is on track to deliver at least two hikes in 2017, maintaining a dovish outlook. However, there is a risk of falling behind the curve against wage growth and political pressures for higher rates. This means Treasury yields have further room to widen, as inflation rises and markets adjust expectations.
Emerging Markets may be at the centre of a perfect storm next year. EM credits face a triple-threat. First, growth could decline on trade tariffs imposed by populist DM governments. Second, capital outflows could hurt EM assets on higher than expected Fed rates and a stronger Dollar. Third, hard-currency debt may come under pressure for issuers with local currency revenues. We remain cautious on EM economies that are exposed to three economic vulnerabilities: dependence to US exports, on hard commodities and on trade links with China.
Until 2016, investors bought equities for yield and bonds for capital gains. We continue to shy away from all ‘low-for-long’ trades and enter 2017 short on rates risk, long on inflation and financial equities and moderately positive on credit risk.
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Alberto Gallo is Head of Macro Strategies and Partner at Algebris Investments (UK) LLP, and is Portfolio Manager for the Algebris Macro Credit Fund (UCITS), joined by macro analysts Tao Pan and Aditya Aney.
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