A detour to the other side of the pond
I have two big picture issues on my mind this morning. The first is the US economy and the US policy response. I think the Neil Irwin piece in the New York Times encapsulates a lot of the thinking on the fiscal front here. I sent him a note, telling him I thought it was a good summation. I also told him that my thinking on the Clinton surpluses is a lot like he postulated – i.e reverse causality from prior mainstream thinking, meaning the boom caused the surpluses. However, I would also say that the government surpluses were also a sign that the boom was unsustainable because it meant private sector dissaving.
One piece that gets at the monetary side of this is from Tim Duy, where Tim talks about the likelihood of a more aggressive monetary response in the next downturn. This is something that Pedro da Costa and Albert Edwards have also flagged. Tim writes:
Finally, in case you missed it, it is worth your time to review the action at last week’s monetary policy forum, paper here, comments by New York Federal Reserve President John Williams here, and comments by Richard Clarida here. A takeaway is that the Fed is preparing for the next downturn with the expectation that new tools need to be ready to address another trip to the effective lower bound. Importantly, the Fed will be looking for tools to prevent downward drift on inflation expectations by, for instance, policies such as makeup strategies that allow for higher inflation to make of for periods of low inflation. I think a result of this work will likely be a more aggressive monetary policy in the wake of the next downturn.
Unfortunately, time constraints mean I will have to get you my thoughts on this in greater detail later. Today, I want to concentrate on Europe.
May’s strategy is empty on all levels
Back in December, when British Prime Minister Theresa May decided to postpone a Parliamentary vote on the deal she negotiated with the EU, I had this to say:
I think Theresa May’s days are numbered. The only reason she remains in power now is that there are no obvious successors. And fear of Corbyn is too great to take a risk on changing leader while the Brexit process is ongoing. This calculus changes considerably if Brexit can be delayed or Article 50 revoked unilaterally, as the European Court of Justice confirmed is possible today.
From a purely political perspective, this makes delaying Brexit past 29 Mar 2019 the obvious priority for the majority of MPs within the Conservative Party who are not committed to a no-deal Brexit. And if that delay cannot be achieved, due to EU recalcitrance, Parliament will be forced to consider revoking Article 50 altogether, simply to stop the clock ticking.
This logic remains very much intact. Hard Brexit advocates in the ERG overplayed their hand in trying to remove May. It was incredibly poor timing. Now she can soldier on for almost a year longer. But, she’s a dead woman walking. Her management and tactics on the withdrawal agreement negotiation have been shambolic. It’s only the fear of a Corbyn government and the no-deal Brexit lever that give her any sway in parliament at all. When her year is up, she’s done.
No-deal Brexit is coming off the table
I think the rebellion against May’s Brexit tactics are about to hot up if she persists in using a no-deal Brexit as a lever to get her deal through parliament. My view remains that the no-deal outcome is not viable politically. And since May’s deal is equally non-viable, we will see an Article 50 delay.
Opponents of Britain crashing out of the EU have three things that make them likely to pull the trigger and force a delay.
- EU support for delay: It is now clear that the EU wants a delay. In fact, Donald Tusk is on record saying that he prefers a long delay to prevent a short delay from creating a perpetual state of Brexit emergency. We’re talking extension of Brexit for two years until 2021. That will galvanize both those who see an extension as giving the British economy room to breathe and those who are hoping for a second referendum
- The increased likelihood of a no-deal outcome: “Exasperation with May’s handling of Brexit is growing in Brussels as senior insiders put the chance of crashing out without a deal at “more than 50%”.” That’s a quote from the linked article above. Alarm is growing both in the EU and in the UK about the economic situation, particularly given the near-recession outlook on the continent. A no-deal outcome would crystallize worst-case recession outcomes.
- Time is short: According to news reports, Theresa May has already been warned by her ministers that she has just two days to agree to a Brexit delay or face a mass revolt. Amber Rudd, Greg Clark, David Gauke and David Mundell are leading this assault, with Rudd the figure most prominently featured in reporting. The Times says “Rudd could be joined by as many as 20 junior ministers and 100 Tory MPs, who, with Labour support, would be expected to defeat May.” And with the Times of London saying May has told Merkel she won’t delay Brexit, the rebels will act.
So, I think this is it. No-deal is coming off the table very shortly. If May insists that she won’t delay and is forced to concede defeat in a vote of parliament, her leadership will be greatly undermined. She can limp on, but I suspect she will be forced to resign since parliament will have rejected her deal by overwhelming majority and voted for a different path in defiance of her will.
Nothing is etched in stone. But I believe we are getting closer to the delay of article 50 outcome that I have been saying is likely since December.
Where would this leave us?
Look at the basket case that is Europe, right now. It may already be too late to prevent a recession, irrespective of what happens with Brexit. Germany is in horrible shape. But, it is in Italy where the rubber hits the road. Recession means larger deficits – likely a serious breach of the Maastricht 3% hurdle. And then we will be back to a standoff between the Italian government and Brussels.
Moreover, soon, Mario “whatever it takes” Draghi will be gone, replaced by a new ECB head. Will that ECB head – say, Peter Praet, for example – do what ever it takes for Italy if it is flouting the deficit rules of the stability and growth pact during a recession? And if he doesn’t, what happens to Italian government bond yields and the capital of Italian banks who own those bonds? I see this as a potentially existential problem, because Italy is not Greece – and because Deutsche Bank, a German bank, is likely to get caught up in this mess, as its capital weakness will make it vulnerable to EU bail-in rules in the next downturn.
All of this dysfunction could be happening against the backdrop of an Article 50 extension. That is not going to make the case for staying in the EU. And so, those hoping that an extension leads to a second referendum may end up disappointed if that referendum turns out exactly as the first did, with Britain rejecting EU membership.
The wildcard in this is Trump. He has signalled compromise on tariffs on China. But he is also threatening Europe with tariffs on their autos. If either of these dust-ups leads to tariffs – especially the one over European cars – Europe will be in a world of hurt. And the Italian ‘excessive deficit’ scenario will crystallize.
The EU simply doesn’t have the institutional architecture in place to tamp down on economic crises in the making. In fact, the rules for the eurozone, the bail-in rules, and the lack of an EU-wide mutualized bank resolution solution means EU recessions will be considerably worse than if the euro didn’t exist. The ECB is also already at -0.40% on its policy rate. And the political opposition to more QE and ECB asset purchases will increase.
While the UK sits outside of most of this structure, it is still inextricably linked to it as a part of the EU. I believe that sets us up for an increase in negative EU sentiment come 2020 and 2021. Moreover, in the coming European parliamentary elections, fully a quarter of the European MPs elected could be eurosceptic or critical of Brussels. That’s a far cry from 10 or 15 years ago when Nigel Farage was the only one who could be said to be of that ilk.
My view: Europe is where the biggest downside risks are politically and economically in the developed world. This is bullish for AA- and AAA- rated eurozone government bonds. But, it’s bearish for European risk assets. Moreover, in a crisis situation, one would expect a flight to the US dollar, the Swiss franc and the Japanese yen, exacerbating any distress in emerging markets, whether that’s Latam, EMEA or Asia.