The European economy has long been bogged down with structural impediments and the challenges of a partially unified single market. Yet in 2017, the European economy experienced a significant pick up. PMIs surged and GDP growth recovered to levels before the 2011 European crisis. Some of the strength has come from a rebound in international trade after European exports picked up noticeably in the second half of 2017 after 6 years of stagnation. Another source of strength has been QE. The ECB balance sheet has increased at over 2.3 trillion EUR since it began buying bonds some three years ago. The weakness of the EUR helped in 2015 and 2016.

Now, however, things are beginning to turn. The Eurozone manufacturing PMI which rose from the low 50s to over 60 has recently retraced sharply to below 57. Industrial production has shown a similar pattern. The ECB’s asset purchases have been extended to September but sizes have been halved from 60 to 30 billion EUR. International trade has begun to slow, and this before material action on tariffs. The strength of the EUR is another complication. Once trading at 1.03 it rallied to over 1.25 and has settled around 1.22. EUR strength will act as a brake on the economy especially since Europe is heavily dependent on trade (which represents over 80% of GDP). And as Europe imports over half of its energy requirements, 90% of its oil, 69% of its natural gas, 42% of its coal and 40% of its nuclear fuels, rising energy prices are a tax on the European economy.

The task facing the ECB is a daunting one. It has begun to slow its purchase of bonds but it hasn’t yet begun to stop accumulating assets although has signalled that it will do so in September 2018. It has not yet raised interest rates and maintains negative deposit and zero repo rates. Its accommodative policy tools are fully deployed and while the economy is still growing that growth has begun to slow. If Europe tips into recession, it has little ammunition left to fight it.

For now, the slowdown is moderate and recession risk is low. There are, however, a couple of sources of risk.

The risk that the trade war resumes is significant. Apart from a general state of strategic competition, trade wars are politically expedient. For the last 5 years China has turned its focus to the domestic economy while the US has re-shored manufacturing (not to mention discovered a lot of oil). Both countries are now less dependent on trade than before despite being the main protagonists in the war. Both will calculate that they have less to lose than the other, and other innocent bystanders, in an escalation of hostilities. Trump may require the diversion for the mid-term elections while Xi, despite recently consolidating power may choose to appease a proud and nationalistic people. He may have won the war within the Party but may still need to win hearts and minds. Europe could be collateral damage in a trade war not of its making. It could choose a side, Europe exports twice as much to the US as to China, but future growth is another consideration. While the US builds walls, China builds bridges and would appear to be a more willing and constructive partner. Europe’s history and scale mean that it is more likely it will be a third player in a trade war, fighting its own corner.

Political risk in Europe has receded in the eyes of the market but remains a significant factor. Emmanuel Macron presses on with his reform agenda despite a series of rail strikes that will last into the summer. His federalist vision is not shared in Germany where a grand coalition governs. If only it were a strong coalition. The CDU/CSU and SPD command but 53% of the vote, while the far right AfD has 13% of the Bundestag seats. Italy as yet has not formed a government since elections in early March produced a hung parliament dominated by populists and Eurosceptics. Spain operates under a minority government and faces secessionists in northern Catalonia. The ECB’s policy will likely be influenced by the fiscal discipline of each member state, which is correlated to the prevailing political regime. The ECB cannot fund a member state but it needs to manage effective interest rates across the union and policy needs to be designed to that effect. The ECB can also influence the level of cross border debt to either discourage a member from leaving the currency union, or defuse the impact of such a member exit. The risk of a member exit is negligible at this point but cannot be ruled out in future.

The ECB meets in a couple of days and it will be interesting to see how Mr. Draghi communicates policy. What he wants is an economy strong enough for expansionary policy to be retrenched, if nothing else so it can be deployed in the next inevitable crisis. His hope is that the EUR retreats and provides some latitude for easing back on accommodation. He may try to talk down the EUR by sounding more dovish. At some stage he will want to stop expanding the balance sheet, maybe even shrink it. And he will need to raise rates into positive territory. (A one-time boost may result from bank lending before rising rates actually act as a brake.) At some point he will want to be more hawkish while sounding more dovish. The days of central bank signalling and clarity may soon be over. As ex Fed Chair Greenspan once said: if I turn out to be particularly clear, you’ve probably misunderstood what I said.

Humphrey: This fake news has to stop and we are going to be the ones who have to stop it. As it is information or possibly misinformation has proliferated around the internet while our reliance and faith in Google or Wikipedia has grown to dependence. It’s a dangerous state of affairs when people trust wholeheartedly news or information which may not be true.

Bernard: Quite so, but what can we do about it? It is quite a complicated problem. Who is to be the arbiter of what is fact and what is fiction? The task would be too daunting for any government to undertake, surely?

Humphrey: Yes, Bernard, but we have to at least have the power to do something, even if we have not the means to do it. The power alone would discourage those who would deliberately spread fake news.

Bernard: But, do we not have legislation in place to deal with defamation, invasion of privacy, hate crime and terrorism?

Humphrey: And sedition.

Bernard: Of course. My mistake. And sedition.

Humphrey: Yes we do. But we face a different kind of threat. We are under siege from technology and the people.

Bernard: The people who vote for us?

Humphrey: The people don’t vote for us, they vote for the politicians.

Bernard: Whom we work for.

Humphrey: Pedantry Bernard? In this quagmire of misinformation and chaos, the people need order, direction, a guide, without which they would be lost, unable to decide whom to believe, to put their trust in.

Bernard: Absolutely Sir Humphrey. We’ve got to limit the proliferation of fake news. So often a rebuttal only fans the flames. We should encourage scrutiny. We should present the facts and let the people come to their own conclusions. We should fight misinformation with greater transparency and more accurate information. That would enable the people to make up their own minds.

Humphrey: Certainly not Bernard! Let the people make up their own minds? Have you gone mad? There would be chaos, they would be lost, unable to decide whom to believe, to put their trust in. We are their guide, Bernard, their beacon. Can you imagine the people thinking for themselves? Parliament would be perpetually hung. Wait… That might be interesting. No. Too unpredictable. Where was I? Parliament would be hung. Yes, we would have a freer hand in policy but just imagine how capricious policy might become as the politicians pander to their constituencies? And the scrutiny Bernard. How can one make policy or execute policy in the face of such scrutiny? Policy is not a simple thing, it relies on trial and error. If we were critiqued for every failure, every blind alley, policy would be paralyzed. No no no no. We need to be able to lead in peace without the constant grumblings of the people driving us to distraction and policy errors. So important a function as government needs calm, calculated and thoughtful consideration which would evaporate in a crescendo of complaint and dissent. It would be impractical. Impossible.

Bernard: But do we not do the will of the people, Sir Humphrey?

Humphrey: Bernard, Bernard, Bernard. If we did so, we would be mere populists. Is that wise?

Bernard: With respect, we appear to be populists every 5 years Sir Humphrey.

Humphrey: And where has that got us? Pandering to the people has led us some of the most misguided policies in the history of the government. The trains. A shambles. It was impossible to run a rail system at those prices, turn a profit and invest in maintenance and improvements. Three incompatible objectives which we failed to present properly to the people. Our reliance on financial services. The City is the economy. No more manufacturing, no more industry, no mining, no steel, no auto industry, unless you count the Chelsea tractors for the rich and aimless, no diversity. We are a hedge fund Bernard. And not a very good one.

Bernard: With respect Sir Humphrey, that’s not entirely true.

Humphrey: Are you calling me a purveyor of fake news? How dare you Bernard.

Bernard: Well, last week in the PM’s office you did say that the idea was not to stop fake news but to monopolize it.

Humphrey: Never said it. Wasn’t there. I believe Bernard, that you’re spreading fake news.

Equities and expensive and credit spreads are tight. Some investors may be able to eke out further returns, even safely, if they are familiar with certain markets such as the ABS and leveraged finance markets. Eventually, given the weight of capital chasing returns, even these pockets of value get crowded. In the long only world, we are wringing out the last bits of opportunity. What comes next is either a lean period or, hopefully not, a crash.

The hedge fund world has promised for almost half a century, to deliver uncorrelated returns, to make money in rising or falling markets. It has rarely delivered. Most hedge funds will run a long biased strategy. Why would they do this? Because its easy when markets are rising, and markets are more often than not, rising. Also, to be really market neutral and deliver a meaningful returns requires quite a lot of leverage and for some reason investors are leery of that. For a time, so were prime brokers. The result is that most hedge funds are exposed to significant market risk.

Private equity may be immune to downturns by focusing on fundamentals and value creation. However, funding costs are a big part of private equity returns and if the bond markets fall or credit spreads widen, the ability of private equity to leverage itself cheaply will be reduced. Also, by eschewing mark to market, owning private equity in a falling market and recession is like having the blinds down in air turbulence. You can’t see it but you can feel it around you.

Real estate of the physical kind is often a haven asset especially when the tangibility of financial assets is questioned. But real estate is a yield play, a fixed coupon investment, albeit with regular rental revisions. Still it is a very long duration investment a leveraged one and it likes falling or low interest rates.

When markets fall, as they eventually do, almost everything takes a loss. The only way to effectively avoid falling markets is to time them and as anyone who has tried to time them or watched professional investors try to time them will know, this is an exercise in futility. So from a practical perspective, you can’t time markets, your hedge funds will be net long, your niche markets will soon be squeezed dry and the current bull market in everything is getting long in tooth.

What not to do: You don’t go short because a bull market is ageing and valuations are high. Shorting requires a catalyst, a tangible reason. One may soon emerge but for now, the economy is fine and liquidity conditions remain accommodative.

Neither do you switch to cash in scale. USD cash is beginning to yield a fair bit compared to the last decade but it’s still yielding very little. Those little pockets of value in leveraged finance and ABS are still good risks for the yield they generate.

But don’t be greedy. When the mass of investors is greedy, it’s time to go on a diet. Reduce market length, reduce exposure but in a smart way. For example, instead of rotating from IG to HY, it may be more efficient to stay in HY but move up the capital structure. Or to buy assets through structured vehicles which may be cheaper.

Brace yourself. It can seem strange to be bracing for hard times when the general conditions are good but as early signs of market fatigue or economic slowdown appear, it pays to brace oneself. Reducing exposure and buying protection are ways to brace a portfolio. Option protection can get very expensive in the middle of a drawdown but there are ways to construct limited protection without overpaying. Using options adds a dimension of control to a portfolio.

In a rising market, stay long and look for bad things. In a falling market, reduce length, maintain a portion of liquidity, and look for good things.

This article was originally posted Sep 7, 2017. It is updated for new trade data Feb 2018.

The Trade War continues. Since 2011, the Obama administration has been actively pursuing a program of reshoring.

http://agmetalminer.com/2015/01/22/obamas-manufacturing-centric-state-of-the-union-youll-never-hear/

Donald Trump’s agenda only seeks to bolster or exacerbate an existing trend. As global growth slows, every country seeks to become more self-sufficient and insular. Trading nations and those with a small or ageing population do not have the back stop of domestic consumption, and will suffer. Populous regions will seek to tap domestic consumption and investment as sources of growth. The strategic responses of the various regions are already becoming clear. China is a prime example with a stated objective of being more reliant on domestic consumption and less dependent on exports.

In China, total trade, here taken to be imports plus exports, have stalled and as a percentage of nominal GDP (ignoring inflation base effects), peaked in 2007 and has since been declining.

(data source Bloomberg)

The decline in trade has also brought with it a decline in manufacturing, as factories facing a foreign export audience are wound down and new ones facing a domestic audience are established. Such a decline has had a transitive impact on industrial commodities.

2016 was a year of recovery in manufacturing, a recovery that has extended well into 2017. This is likely a rebound due to the differential times in decommissioning old, export facing assets, and building new, domestic facing ones. The rebound has reversed the decline in manufacturing and commodities. A growth rebound also impacts demand for imports and reverses the decline in global trade. However, this is reactionary rather than causal. As the world’s productive assets settle into a new equilibrium, trade will stabilize at a lower level. If countries like the US under Trump accelerate protectionist policies, trade could resume its decline. In any case, lower trade is inflationary, ceteris paribus.

The fact that inflation is weak is all the more concerning in the context of reduced trade. It suggests that median output and income is weaker than mean (average) metrics. This could likely be due to a skew in the population for output and income data. In fact it supports the anecdotal evidence that wealth and to a lesser extent income inequality is acute in the developed nations.

The Trade War hypothesis is part of a more general and pervasive adversarial world. We see examples of this in the failure of the Accord de Paris, Brexit and the perceived Siege of Britain, protectionism in the US, Chinese policy to maximize FDI and minimize ODI (which is the investment analogue to trade war), China’s belligerence in the South China Sea, to name but a few.

In such environments, self-sufficiency is a sound but ultimately costly strategy, provided one has the resources. Countries lacking in land, resources, labour and knowledge, will have the most difficult run of it. Collectively, self sufficiency is costly and results in lower growth at all price levels