Mid-Year Musings

  • Mid-Year Musings
The first half of the year has flown by. Much has changed: threats to the European Union’s survival have faded, the U.S. Federal Reserve has become less accommodative and China has tightened up on credit. Other things have not changed: American policy-making remains deeply divided, equity markets are still rallying and Europe still needs a lot of structural reform.

The remainder of 2017 promises to be eventful. The following are key themes we will be watching in the months ahead.

Politics and Policy

Many economists upped their U.S. forecasts after last fall’s election, expecting a flurry of health care reform, tax relief, deregulation, and infrastructure spending. We were not among them; even prior to the election, the political dynamic was hostile to advancing legislation of any kind. It went beyond friction between Democrats and Republicans; factions within the Republican Party have been battling as well.

We still do not think that there will be major changes to U.S. tax and fiscal policy this year, or even next. Nonetheless, optimism among consumers, investors and businesspeople remains high. Some markets (currencies, interest rates) have retraced their steps over the past six months, but equity markets have climbed resolutely upward. Corporate earnings have been strong, even in the absence of favorable legislation.

The upbeat outlook may be challenged this fall, when the Treasury runs out of borrowing room under the debt ceiling (right). At that point, the fractiousness in Washington could result in an interruption of government (and potentially a ratings downgrade). For now, spirits are high. But the question of how dependent asset prices are on the achievement of the Trump agenda remains unanswered.

The Votes Are In

Last winter, the European continent was filled with dread over the future of the European Union (EU). Euro-skeptics Marine Le Pen and Geert Wilders were polling as favorites for the French and Dutch general elections, respectively. The moderate Italian Prime Minister Matteo Renzi had just lost a referendum and the populist Five Star Movement appeared to be in the ascendency. The common market seemed to be facing an existential crisis.

How things have changed. Geert Wilders is barely a footnote in Dutch politics at the moment, and the French turned resoundingly away from the National Front. German elections this autumn have now turned into a virtual non-event, as Angela Merkel is expected to ride home comfortably. This will allow her more room to work with France’s Emmanuel Macron towards forging a closer EU.

Even if we have an upset in Germany, it is unlikely to disturb the apple cart since Merkel’s rival Martin Schulz, of the Social Democratic Party, is perhaps the strongest supporter of EU integration in frontline European politics. He could also help correct some structural imbalances in the Germany economy, such as low wages and tight fiscal policy.

On the other side of the Alps, Italy could be witnessing the return of more familiar political forces as the center-right parties have gained ground in recent local elections. National balloting is likely to be held in the spring of 2018 under a new electoral regime.

While Europe’s populists have failed to advance at the ballot box thus far, it would be a miscalculation to dismiss them entirely. Until governments address the concerns of the aggrieved, the potential for renewed euro-skepticism remains.

The South Will Rise Again

The Mexican economy has encountered a difficult series of challenges in recent months. The peso has endured wide movements, inflation is at a multi-year high, interest rates are elevated and the country is dealing with a challenging phase in its relationship with its northern neighbor.

The peso lost more than 20% of its value between November 2016 and January 2017 in the wake of the U.S. presidential election. Threats by the U.S. to upend the North American Free Trade Agreement (NAFTA) and introduce steep border taxes did not help the outlook for Mexico; neither did the frosty relationship between the presidents of the two countries. But as the most extreme U.S. proposals have become less likely, the Mexican currency has regained lost ground.

Improving Mexican fundamentals have also helped. The current account balance has been improving, portfolio flows are not problematic, and the non-oil trade balance shows a trade surplus for the first time since 1995.

The recent increase in the Mexican policy rate is possibly the end of a hiking cycle designed to contain inflation. The currency is anchored, inflation is predicted to retreat, and real economic growth has surpassed expectations.

There are, however, risks to consider. NAFTA will be reopened, and it is unclear how extensive alterations might be. Any hints that the Fed may shrink its balance sheet or raise rates faster than market expectations will work against the peso. Nonetheless, the economic tone surrounding Mexico is considerably better than it was six months ago.

Bailout or Bail-In?

Europe witnessed two cases of bank failure this month. The first was the collapse of Spanish banking group Banco Popular. It was taken over by rival Santander after it endured a run on its deposits. The Spanish taxpayer was not on the hook, as Popular’s shareholders and junior bond holders absorbed the losses. Essentially, the banking resolution system worked as European authorities envisaged it should.

While Banco Popular’s transition was seen as a successful test case for the new banking regime in Europe, the dissolution of two Venetian banks just weeks later came as a rude shock. Failing lenders Veneto Banca and Banca Popolare di Vicenza secured EUR 5.2 billion in public funds and an additional EUR 12 billion in government guarantees, even as its good assets were taken over by the Italian lender Intesa Sanpaolo. In contrast to what occurred for Santander in Spain, senior bond holders will be made whole by the Italian tax payer.