Fra Unicredits chefanalytiker Erik Nielsen:
“Uncertainty” is indeed the key word now, so let me dedicate today’s “last before summer” note to an annotated list of the ten most important issues for Europe and the world right now, as I see them. They’ll surely all play out for many years to come, but I’m pretty sure we’ll get some rather clear signs of the direction already before the end of this year. Here we go:
1. Will the pandemic remain under control or will we need another lockdown to contain a second wave? How the pandemic develops until we get a vaccine or other medical treatment (in maybe a couple of years’ time?) is – without a doubt – the single most important issue facing us today, both as it directly impacts people’s health and livelihood, but also as it’ll impact politics, policies and hence the growth prospects.
While it seems that we have to learn to live with frequent news about the risk of a second wave of the pandemic, I think Europe has the testing, tracking and treatments sufficiently under control so that new episodes of infections will be spotted early and dealt with locally. (Here in Germany, we celebrate that yesterday had zero deaths from COVID-19, which is only the second such day since March.)
So, on balance, I don’t think a general second lockdown is a likely scenario in Europe. I’m more worried about the US – about the pandemic, and about the growth outlook. While the R-naught has now fallen below one in a couple of hard hit Southern and Western states, for the US as a whole, the picture remains grim. Yesterday was the fifth day in a row with more than 1,000 deaths from COVID-19. Total US deaths have now surpassed the EU, even though the US population is 118 million smaller.
Apart from the human disaster, I worry about the effect these numbers may have on US growth, whether via future formal lockdowns in some states or due to voluntary restrictions on activity caused by fear. This past week’s jobless numbers certainly suggested that the recovery is taking a breather, if not even being derailed. If so, this would have an unfortunate spillover effect to the rest of the world. I’m also very worried about the capability to deal with what looks like a rapid spreading of the virus in several major EM countries.
Global trade is not doing well, and it is difficult to see that change any time soon, so – for Europe – domestic demand has to be fueled.
2. How fast will US-Chinese relations deteriorate, and what will be the consequences for Europe? I discussed the rapidly deteriorating relations between the US and China in my Sunday Wrap last weekend, as well as how the US is leaning increasingly on Europe to abandon Huawei. This past week saw further acceleration in these tensions: On Thursday, US Secretary of State Pompeo delivered an extremely hostile speech on China, defining confrontation across a host of issues (https://www.state.gov/communist-china-and-the-free-worlds-future/).
For a persuasive interpretation, I recommend Brooking’s Thomas Wright’s piece in The Atlantic: https://www.theatlantic.com/ideas/archive/2020/07/pompeossurreal-speech-on-china/614596/ Pompeo’s speech came as – more symbolically – the US closed the Chinese consulate in Houston because of accused spying, and – in reaction – China closed the US consulate in Chengdu. And there were additional reports this past week of plans to ban TikTok (the Chinese app used for short videos by, among others, comedian Sarah Cooper’s hilarious mimics of Trump) as well as several other companies.
Also this past week, following the UK’s banning of Huawei from the 5G roll-out, the French National Agency for the Security of Information Systems announced that French telecom operators won’t be allowed to renew their 3-5 year licenses they just received to use Huawei equipment. Germany is reportedly “still thinking about it”, but the pressure is building to follow suit, a stance referred to (in poor disguise) by Pompeo.
It’s clear that the US has decided to take on China across several policy issues, but particularly in the field of technology, and that they’ll go a long way to push Chinese tech companies out of the US and America’s traditional allies. I suspect Europe will need to choose sides during the next six months for their providers of equipment for at least their 5G roll-out.
In all probability, Europe will fall in line with the US on these security-related issues, so the outstanding question will be the Chinese reaction. To get a taste of what may be coming, according to the FT, Chinese (state directed) media accused this past week HSBC for having followed US orders to set up a trap to ensnare Huawei and its CFO (and daughter of the founder) Meng Wanzhou, presently under arrest in Canada, where she is awaiting the outcome of an extradition case to the US. (HSBC has denied this in a social media posting in China earlier today.)
And earlier this week, the Wall Street Journal reported that the Chinese ministry of commerce is considering banning Ericsson and Nokia from exporting 5G antennas, which they manufacture in China, if EU countries ban Huawei from 5G. US-Chinese tensions will surely be a multi-year (if not even multi-decade) issue, but the next five months could well set the stage for how Europe needs to cope.
Ultimately, the solution lies in the development of a competitive European tech industry, as broadly envisaged in the “Next Generation EU” agreement on Tuesday.
3. Who’ll win the US election in November and does it matter? As I’m sure you know, the opinion polls point to a Biden victory in November by a decent margin, and US political analysts suggest that the party of the next president will likely also carry both houses of Congress, giving the next president considerable scope for policy changes. And yes, it matters who’ll be in charge!
Yet, do remember that three months is a long time in politics, so nothing is clear yet, as far as I’m concerned. (But then again, the more TV interviews Trump gives to explain how amazing he and his doctors find it that he can memorize the sequence of “person, woman, man, camera, TV” in mental tests, no kidding, the more likely I assume it’ll be to the American electorate that they may benefit from a different president.)
Of course, if the election were to be a close outcome, there is a considerable risk that the result will be challenged and potentially go all the way to the Supreme Court, adding extended uncertainty and chaos to the process. My two cents worth is that another four years of Trump will be a disaster for the US and for the world primarily because of the destruction of organized policy making he has overseen and the further erosion of the very institutions that are the pillars of a liberal democracy.
But markets might still like a Trump victory, at least short term, as he might deliver another major corporate tax cut and further deregulation in an attempt to restart the economy. In contrast, a Biden victory would surely see a restoration of more traditional policy making processes, as well as a return of the US as an active and leading member of the group of democracies, including via a return to the Paris Accord and – probably – the Iran agreement.
But I strongly doubt a Biden administration would reverse recent years’ confrontation with China; that conflict “has left the station” and the best we can hope for is that it gets managed properly from both sides, and doesn’t leave third parties stranded in the middle. In this respect, I’m very sure that Biden would do a better job than what we have seen these past three years. Domestically, with a Biden presidency, we’ll almost certainly see a measurable move to the left (i.e. towards European standards), including via a hike in US corporate taxation, re-regulation of US industry and possibly an increase in the minimum wage.
In all, these are policies which are unlikely to be welcomed in the short term by financial markets (although they should be – because of the longer term.)
4. Will the EUR 1.8 trillion multi-year budget and recovery fund get approved by all the necessary parliaments, and will it be ready for operation by January 1? As far as I can judge, the odds are good for both the final approval of the plan and for its preparation to become operational from the beginning of 2021. That said, it’ll be worthwhile to keep an eye on the process through particularly the European Parliament, and what they may attach in terms of conditionality on the issue of the rule of law – and, in reaction, how that then fares in Poland and Hungary.
Of course, both countries stand to be huge net financial beneficiaries of the deal, so it would be quite something for any of them to block it. In Poland, more than in Hungary, I suspect the risk of ideology could play havoc, particularly if Kaczynski decides to pull his nationalist strings within PiS. Assuming it gets approved, I’ll then keep an eye on the work to define the legalities and operational aspects of starting to borrow the EUR 750bn in the common name of the EU.
For the legal issues involved, I highly recommend Harvard’s Sebastian Grund’s tweet thread of July 22. In addition, there are some interesting political issues involved, not least to what extend the EU will issue green bonds. As Blackrock’s Isabelle Mateos y Lago has pointed out in a tweet, if the EU chooses to issue green bonds to fund the 30% of the EUR 750bn intended to finance green projects, they would quadruple the euro-denominated sovereign green bond market, which is an interesting perspective!
And, of course, those hoping to invest the EUR 390bn in grants for future generations (roughly EUR 80bn in Italy, EUR 73bn in Spain, EUR 40bn in France, etc.), the governments will have to submit a “recovery and resilience plan” to be approved by the European Commission and the Council (by qualified majority). These plans will be interesting – and good fun – to study as they make their way to Brussels. Hopefully, this process will gradually develop into a greater degree of cooperation between the national authorities and the Commission in the formulation of concrete policy actions to meet Europe’s common policy priorities.
5. Will the eurozone now – finally – complete the Banking and Capital Markets Union? I hope so – and I think there is a good chance! The good news is that the topic has gained more recognition in recent months, including in Berlin, and that it has become evident (to most) that the “banking” and “capital markets” unions should be thought about as two sides of the same coin. The efforts need to recognize that several European banks have become – de facto – “uninvestable”.
This means that while the banking system is now “part of the solution” to the crisis, there is a risk that it could become “part of the problem” as banks’ balance sheets get impaired by the rise in corporate defaults as a result of the crisis, which, along with meagre earnings prospects, make it difficult to imagine that sufficient amounts of capital can be attracted over the medium term – unless, i.e. there is a change in policies.
Such changes in policies should include: (i) the development of the capital market with incentives for both investor and companies to move from debt to equity, (ii) regulatory incentives for banks to consolidate across different geographies which will help diversify their exposure, thereby making them safer, (iii) arrangements for European “bad bank” to which banks can sell bad assets, and (iv) a streamlining of the overall regulatory regimes imposed by the multitudes of agencies.
(And yes, banks should be pushed further to cut costs to bring cost/revenues down to, e.g., no more than 2/3.)
6. Will the UK’s transition period away from the EU really end at the end of the year, and will there be a deal or will it be a cliff edge exit? It’s not been a good few weeks for the UK and Boris Johnson: The EU’s chief negotiator Barnier said this past week that without movement on the UK side, including in areas which the UK government so far has identified as red lines, there won’t be a deal to replace the present transition arrangements.
The Daily Telegraph (long-term sponsor of Boris Johnson, a prominent Brexit-paper and frequent loudspeaker for No 10) replied yesterday with this absurd headline: “If the EU wants a deal the solution is simple: fire Michel Barnier”. Meanwhile, the FT reported this past week that UK and US trade negotiators have let it be known that the much touted “easy” trade deal between the two sides is not so easy to reach after all, and it certainly won’t be done before the UK leaves the transition period with the EU at the end of this year.
And there is a looming trade war with China over Hong Kong and Huawei. As the wheels are coming off all Boris Johnson’s bravado of “global Britain” and easy trade deals, and as – after much delay – the report on Russian interference in the Brexit referendum and UK elections and politics more broadly (with some awful looking coziness between Johnson himself, the Tories and Russian oligarchs was laid bare), Boris Johnson himself headed to Scotland in an attempt to keep the Dis-United Kingdom together (in the interpretation of the FT).
To me, it seems clear that the UK is entering its greatest political (and maybe economic) crisis in decades. And for the most urgent task, the past few weeks have made it clear that the transition period with the EU will indeed end on January 1. Yet, while recent statements from the two sides certainly makes it feel like a cliff edge exit (or “hard Brexit”), I still think those statements should be interpreted more as warnings rather than predictions.
There just seems to be too much at stake for the two sides not to reach at least a bare-bones trade deal with enough on the financial services side to avoid too great disruptions. Apart from the fact that we now think it very unlikely that the transition period will be extended, the note still stands. What will be the balance between fiscal and monetary policies in the eurozone? Easy: More of both!
This past week we saw not only the EU package, which will provide fiscal stimulus across the EU on the order of 1 ¾% of GDP in each of the three years from 2021-23 (and a bit more than that in the Southern European and CEE countries, a bit less in Northern Europe), but further action on the national fiscal front. Italy announced additional stimulus of EUR 25bn this year (1.4% of 2019 GDP) and EUR 6.1bn for next year (0.3% of 2019 GDP).
My strong feeling is that more countries will follow suit because – as we have discussed for the past month or two – consumers and businesses will need stimulus to get GDP back to pre-crisis levels. At a minimum, the job retention schemes, many of which will expire later this year, are bound to be extended. As I have argued for a long time, policymakers don’t run out of policy tools, and apart from the obvious (namely that governments step in to protect the population to the extent possible during crises), the politicians will have noticed how their opinion polls have benefitted from this new degree of policy action.
Meanwhile, the ECB will keep in place its three fundamentals for its crisis policy: (i) This necessary fiscal expansion will not be allowed to lead to a tightening of monetary conditions; (ii) This statement applies to all constituencies of the eurozone (combined this means de facto “yield curve control” to prevent any upward shifts, or sovereign spread widening, even if this means deviation from the capital keys); and (iii) the long-term objective of returning to the capital keys will not be allowed to dictate policies.
In all, this means that the ECB will most likely add to the PEPP before year-end – and down the line, they’ll need to find a way of merging the traditional QE with the PEPP.
8. What will the credit rating agencies do? My bottom line is this: While I disagree with the rating agencies’ approach and analysis of sovereign debt, on the key economic data they use, particularly fiscal deficits, public debt and growth, several countries should be downgraded now by 1-3 notches (again, I don’t agree with this, but this is apparent if you replicate their framework.)
But several factors are – rightly – holding back the rating agencies. In Europe these include the fact that the ECB is now conducting policies basically in line with those of other major industrialised economies, as well as the broader European approach now having been agreed on. As the message from Berlin, Paris, Brussels and Frankfurt (and assuming the EUR 1.8 trillion EU deal gets approved) has become ever clearer and louder, it seems overwhelmingly likely that the rating agencies will have no choice by to delay any change to their outlook (let alone rating) until at least the second half of 2021.
But that said, I’ll keep a close eye on what they do at the next rounds of reviews.
9. Markets will be chasing this “new European vision”: “Eurozone assets caught between US-China tensions and historic EU agreement” But here are three market segments I’ll be watching with particular interest during the rest of the year as global financial markets are turning bullish on Europe due to:
(i) the better handling of the pandemic crisis than in the US, (ii) greater questions on EM, (iii) the continued European policy stimulus, (iv) the clearer “vision” now articulated and funding identified, and (v) the fundamentally cheaper assets than in the US.
If market were to exceed (or deviate from) our forecasts, I think these would be the areas to watch: First, could key European equity indices return back above pre-crisis levels, i.e. broadly another 10% upside? – e.g. could Stoxx600 hit 430 again? Second, could the 10-year BTP-Bund spread tighten back inside the approximately 118 low for this year? – Could we even see a two-double-digit number before the year is out?
Third, with inflows likely to pick up to chase cheaper European assets, could EUR/USD move to 1.20? – and will the ECB then begin to make noise? I wouldn’t bet my house on these levels, but I’m confident the direction is right. 10. What are the “unknown unknowns”? By definition, surprises are terribly difficult to predict …. So what have I missed?
Best Erik
