The October Market Pulse 2019

Draghi moves on

Having committed the European Central Bank (ECB) to preserving Europe’s monetary union, Mario Draghi has left the building. Gavekal Research notes that the pledge in 2012 to do “whatever it takes” and the creation of the still-unused Outright Monetary Transactions programme — a facility that lets the ECB buy unlimited debt from a country in a formal bailout programme — effectively saved the single currency. His commitment fixed a flaw in the Eurozone’s design by making the ECB a lender of last resort for sovereign states.

The necessity for such a role is graphically illustrated below, a chart which shows the current TARGET 2 balances at the ECB and the inherent fragility of the Euro. If there is an economic argument to leave the EU, it lies in these dangerous imbalances created by a single currency formed without a fiscal union. Essentially, the Trans-European Automated Real-time Gross Settlement Express Transfer System or TARGET 2 balances comprise the accumulated assets or liabilities built up between the Central banks of member states as a result of current account balances and capital flows. The promise to do “whatever it takes” effectively means that the ECB minimised the probability of a default by simply stating it would assume the liabilities of a deficit country if it defaults. It is the ultimate monetary bluff and the biggest risk for the Euro project.

Material TARGET 2 balances at the ECB

The way to prevent these imbalances in a united Federal system would be relatively straightforward. Assets are simply transferred from the surplus countries to those in deficit. That is, fiscal transfers are made from the overflowing coffers of the Bundesbank in Germany to the deficit accounts in Italy, Spain, Portugal etc. - a notion that is not particularly popular in Berlin but one that has been rejuvenated recently by President Macron and Mario Draghi in the context of a fiscal transfers within the Union. Fiscal transfers are a movement of capital, so the imbalances would moderate over time.

It should be noted that France has nothing to lose from such a proposal since the French TARGET 2 balance is minimal and Italy would have much to gain. Resolving the imbalance completely via fiscal transfers would involve the transfer of a trillion euros out of Germany and Luxembourg, which neither country has an appetite to entertain. The problem cannot be solved via the normal channel of currency appreciation or depreciation while the euro exists and is likely to continue to grow over time. Theoretically, this situation is sustainable while the ECB continues to be trusted as the lender of last resort but the credibility of that commitment will be scrutinised as the liabilities grow. The risks to the Eurozone are clear and Christine Lagarde will need her best game face at the table as she assumes the mantle of the most critical role in Europe.

Improvements at the margin

In the latest Brexit developments, the virtual removal of the prospect of a “no-deal” Brexit has produced a relief rally in the pound and a small relative under-performance of UK equities. Compared to the MSCI World, the MSCI UK has lagged by about 1.3% since the end of the meeting in the Wirral between Varadkar and Johnson. However, the pound has appreciated by nearly 5% versus the US dollar, highlighting the relative value of the currency. On a producer purchasing power parity basis, sterling remains 20% cheap relative to the dollar and about 10% cheap relative to the euro. Using the famous “Big Mac” index, a burger will cost you 28% more in the US and a staggering 52% extra in Switzerland!

US$/£ Big Mac Index

We remain positive on UK equities from a valuation perspective and would expect foreign investors to ease back into the UK to bargain hunt as the fog and uncertainty of Brexit clears.

Investors have also been cheered by a potential truce in the trade war between the US and China with China promising to keep the currency stable and the US agreeing not to impose the additional tariffs that were due to come into effect on 15 October. As deals go, this one looks like fairly slim pickings, but it would seem that anything is better than the alternative and equities have recovered as a result.

Investment is the weak spot in the global economy today and the hope is that a US/Sino cease-fire will oil the wheels of commerce. While there have been multiple false starts on the trade front over the last 18 months, it would seem reasonable to expect the Republicans to be wary of a recession in an election year and put the rhetoric on hold for a while, but I would not expect to see a sudden flood of investment returning as a result. The US/Sino relationship is far from settled and will be an ongoing friction that businesses will have to normalise over time.

US Non Residential Investment (%YoY)

In the meantime, the consumer is supporting global growth and is in good shape, unemployment is low and real wages are strong. Lower interest rates help financing costs and the injection of liquidity by Central banks earlier this year suggest that growth will broaden and stabilise in the final quarter. Over the last 10 years, consumers have generally “restructured” their personal balance sheet, particularly in the US, and according to TS Lombard consumer debt to net worth has not been this low since the early 1980s. TS Lombard further notes that lower rates were intended to signal consumers and companies to spend but, in fact, they were interpreted as a sign of lower growth. In addition, as discussed in last month’s Pulse, savers have had to save more to generate the same level of income. The asset base growth for savings in the US has been in treasuries, corporate bonds, money market funds and equities. Therefore, the US consumer is much more vulnerable to both a rise in interest rates and a stock market correction than in the past, hence president Trump’s obsession with the stock market and his bullying of Jay Powell at the Fed.

Banks have also improved their balance sheets and most have healthy Tier 1 capital ratios following regulatory reforms. However, developed world banks also have the highest exposure to corporate credit since the period 1969-1975, as companies have reduced equity in the capital structure in exchange for debt. This suggests that any shock to top line revenue growth as a result of a recession would have a strong negative impact on bank earnings and liquidity. In other words, the banks have been encouraged by extraordinary monetary policy to exchange the excess mortgage exposure of the last cycle for excess corporate debt. Mortgages are down to just 52% of outstanding loans today versus a high of 67% before the last recession as the banks moved on to the new “new thing”.

For the time being, low interest rates available in the corporate debt markets minimise the risks of default, but they also encourage leverage ratios to rise even further until a tipping point is eventually reached. Just like the parable of the scorpion and the frog, it is sadly the inevitable truth of investment banking DNA that, eventually, they will surely be architects of their own demise. Defaults can absorb capital buffers remarkably quickly and the German banks are a notable area of vulnerability. From an operating perspective, German banks collectively generate a pitiful return on capital of just 1.8% on average compared to the 7.8% average for Europe as a whole. A negative cost of debt funding the asset base means that this situation is sustainable for now, but with Germany potentially in a technical recession, the default risks are rising.

US Rules

The last three years have seen the US equity market deliver significant outperformance relative to the UK, Europe and the Emerging Markets. The gap, according to Gerrard Minack at Minack Advisors has been driven by better revenue growth and better operating margins. Minack now suspects that US margin expansion has peaked. Labour is demanding a bigger share of the pie in America and non-US corporations have a higher potential for margin expansion. More importantly, he notes that if there is a US/China trade truce and the Federal Reserve prevents a hard landing recession scenario, the more cyclical markets of Europe, the UK and Emerging Markets will close the gap opened up by US performance.

This reasoning chimes with our view that growth stocks are expensive compared to cyclical value and that if we see a modest recovery in activity in 2020 the excessive performance gap of growth versus value would close. However, in my view, it is too early to say that the current caution infecting corporate investment has bottomed and that we can discount the risk of a recession in 2020. Monetary policy has reached its limits and the global economy is vulnerable to political policy error as a result.

The expectation and recommendation from the monetarists is that now is the time for fiscal expansion, financed by low cost debt rather than taxes, and if we see more concrete signs of this, the outlook for 2020 would improve materially.