Article / 29 July 2016 at 16:00 GMT

Monthly Macro Outlook for August

Head of Macro Analysis / Saxo Bank
  • Investors are shrugging off growing political risks... for now
  • Eyes are on central banks, with more easing expected in the UK and Turkey
  • Janet Yellen may offer clues to a September rate hike at Jackson Hole event
  • US election campaigns gear up, with outcome more unpredictable than ever
  • Poland's economy brightens, Finland business confidence in perpetual gloom
  • Turkey's credit rating taking a beating in aftermath of failed coup 
Turkey coup
Geopolitical risks are on the rise, and could become the main driver in global financial markets. Photo: iStock

By Christopher Dembik

“Political risk is on the top of the agenda”

Investors have learnt the hard way that there is no quiet summer for financial markets. Since the victory of the Leave campaign in the United Kingdom, the risks have increased considerably. Red warning lights are flashing on the global economy once again. Worldwide PMI surveys show the global economy just had its worst quarter since 2012, the first signs of recession are popping up in the United Kingdom, and, moreover, geopolitical risk continues to grow, particularly in Europe. It could be the main driver of the financial markets and the global economy in the coming months. 

The main paradox of this period is that the risks have never been so numerous, and yet, investors seem to be quite confident in the future. Citi’s Macro Risk Index is currently at 2.24, which shows that investors are pretty relaxed. The gap between the vision of the market and the economic situation cannot last long. Sooner or later, there will be a brutal return to reality.
In August, all eyes are on the central banks. Further easing of monetary policy is expected by the Bank of England and the Turkish central bank, and investors' main focus will, once again, be the Jackson Hole Economic Policy Symposium taking place August 25-27 in Wyoming. 

This year's topic will be: “Designing Resilient Monetary Policy Frameworks for the Future”. Janet Yellen’s speech will be closely monitored by investors looking for clues about the evolution of US monetary policy and, in particular, the possible outcome of the Federal Reserve’s September meeting, which is probably the best opportunity to hike US rates this year.

Global overview: Rising political risk

Risks are growing, and investors still seem fairly relaxed. Citi’s Macro Risk Index, which gauges risk aversion, is at 2.24%, which means investors are not worried at all regarding the future. The same optimism can be seen in Barclays’ Emerging Market FX Risk Index, which recently reached its lowest point since the beginning of the year. Risk is clearly not priced in by investors, and the significant gap between investor perception and economic reality is unlikely to last long. The return to reality will be difficult. 

Macro Risk Index
 One of the possible triggers could be a critical increase of political risk in the coming weeks. Six key elections and referendums will take place between September 26 and November 8, in Europe and the United States. 

The referendum in Italy could lead to the resignation of prime minister Matteo Renzi, and open a new page of political instability for the country at the worst time, since the problem of the Italian banking sector is still pending. In Hungary, the referendum on migrant quotas could confirm the inexorable rise of populism in Europe, and constitute a new setback for the European Union just a few months after Brexit. 

While these events have very little impact by themselves, an accumulation of risks over a very short period could have a negative effect on financial markets, and increase Europe’s crisis of confidence. From September, investors won’t have time to breathe. Political risk is at the top of the agenda.
Political risk
On the brighter side, central banks still have ways to calm markets in the short and medium term. Their action was certainly decisive in avoiding a financial panic in the wake of the UK referendum. Nonetheless, central bank omnipotence is on the wane and central planner risk may be higher in coming months than ever before, with few tools left and key governments, like that of the United States, frozen by election. 

The latest BIS annual report was very clear: we are at the limits of central bank policy because of diminishing returns and higher risk of speculative bubbles. Despite more than 660 global rate cuts since Lehman, growth is still subdued. Central bankers have no precise idea what to do next, but the market doesn't seem to be worrying about it for the moment.  

In that regard, investors will focus on Janet Yellen’s speech at the Jackson Hole Economic Policy Symposium in Wyoming. There isn't much to expect, however. Direct information about the timing of the next rate hike will certainly be scarce. Short-term risks, notably linked to Brexit, are diminishing, but the outlook for the US economy is still mixed. 

The labor market and consumer spending are following a positive trend, but GDP is showing signs of weakness. Headline GDP in Q2 was a big miss (1.2% vs. 2.5% expected) and GDP in Q1 was revised downward (0.8% vs. 1.1% at the first estimate). The best window of opportunity to hike rates this year remains September, but the final decision of the FOMC is closer to 50/50, and will strongly depend on economic data collected in July and August. It's too early to have strong conviction regarding the Fed’s September meeting.

United States: The election is not a foregone conclusion

The other US driver of capital markets will be the presidential election. The campaigns will intensify now that the party conventions are over, and the result of the election is more unpredictable than ever. The unexpected outcome of the UK referendum is the best proof that nothing is written in advance. It would be risky to believe the US presidential election is a foregone conclusion and that Hillary Clinton will be the next president. The gap between the two presidential hopefuls has narrowed considerably in recent weeks, and corresponds more or less to the margin of error. 

Many voters who feel they did not benefit from the economic recovery will probably be seduced by Donald Trump’s populist and anti-establishment views. On the other hand, US demographics undeniably work in Clinton favour. The result of the election will closely depend on the participation rate of young voters and ethnic minorities, two groups that are traditionally likely to vote for the Democrat candidate.

Presidential poll
Based on a historic analysis of the average S&P 500 return during presidential terms from 1930 to 2015, it appears a Democrat president is more beneficial to capital markets than a Republican one. The S&P 500 increases on average by 11.38% during the first year of a presidential mandate when the leader is a Democrat, and drops by 1.27% when the president is a Republican. 

At the end of the mandate, the difference is just as striking. In the fourth year, the S&P 500 increases by 9.65% under the Democrats, versus a 0.62% increase when the Republican Party is in charge. This analysis obviously doesn't take into consideration a number of other factors (political affiliation of the US Congress, oil prices, monetary policy etc.) but it seems to corroborate a diagnosis largely shared among the business community: Hillary Clinton, who is more pro-business and has supported free trade throughout her career, would be better for the S&P 500 than Donald Trump. 

However, it is likely that a Trump victory would not have a strong negative impact on the market, at least not in the short term, due to the fact that investors have already anticipated this possibility. The scenario that the market is not pricing in is Trump getting elected and the Democrats winning the House of Representatives. This could lead to a political deadlock similar to the fiscal cliff that occurred at the end of 2012. It would be the least favorable outcome of the US presidential election for investors, and would take time to get used to. Meanwhile, volatility would increase in capital markets.

S&P return during presidential terms
Western Europe: “It’s all the fault of Brexit”

In Europe, the economic growth trajectory remains uncertain. It will be very easy to blame Brexit for decelerating growth. However, the process of declining growth started at the beginning of 2016. Europe and the United States are approaching the end of the business cycle. In the United Kingdom, construction PMI, which is an early indicator of GDP trend, has already been in contraction for a few months, confirming the UK economy would have slowed even if the country had voted in favor of Remain. The outcome of the UK referendum will only accelerate the process. 

According to preliminary statistics, the United Kingdom will be hit hardest in the short term. PMIs point to post-Brexit UK economic contraction not seen since 2009, while CBI business optimism fell to -47 in July from -5 the previous month, which is the lowest level since 2009. Recession is clearly on its way as expected by the Bank of England. The central bank opted for the interest status quo in July, but could decide to lower rates at the upcoming meeting on August 4, since early signs confirm the economic slowdown in the aftermath of Brexit. The consensus expects that interest rates will be lowered by 25 basis points. 

It’s only a matter of time before the United Kingdom will ease monetary policy further. The key immediate challenge for the United Kingdom will be to deal with an important current account deficit, reaching almost 7% of GDP. The weaker pound will obviously help the economy but there is a real risk that services surplus shrink in the coming quarters. 

However, in the long term, optimism prevails for the British economy. The UK is certainly the only country that could successfully overcome the challenges of an exit from the European Union. As for the EU, the impact is still difficult to estimate. According to Bloomberg consensus, Brexit could lower GDP in the euro area by 0.1 percentage points in 2016, and by 0.3 percentage points in 2017. These estimates need to be taken with caution due to numerous uncertainties concerning the political process that has just started.

UK consumer confidence
The EU's other concern is the health of the Italian banking system, which has been deteriorating slowly but steadily for many years. Bank bad loans as a percentage of the total lending book reach 1.5% in the United Kingdom, 5% in France and 18% in Italy. In total, NPLs in the Italian banking sector amount to EUR 400 billion -- that's equal to 20% of Italy’s GDP. However, only 10% of this amount represents a real immediate risk. It is a critical level, but, by no means, an insoluble problem. 

What is lacking is the political will to act. In fact, Italian banks are the tree that hides the forest. The main issue for Italy is the lack of economic growth, despite structural reforms, notably in the labor market, implemented by Matteo Renzi. At constant prices, the Italian GDP has not increased in the space of 15 years. That's 15 years of no growth. The problems of the banking sector will be solved, but it will resurface sooner or later, if the country fails to create sustainable growth. 

Italy GDP
Asia – Pacific: The ball is in the government’s court in Japan

In Japan, the timid measures unveiled by the central bank in July, consisting of doubling equity ETF purchases to 6 trillion yen per year, and doubling the size of the US dollar lending program to support Japanese companies’ operations overseas, will force the government to step in.

Three conclusions may be drawn from the BoJ meeting: 
1) The central bank implicitly acknowledges that it does not have much room left to act in the current monetary policy framework. It is already buying more than 90% of the country’s newly-issued debt, so increasing the purchases is quite difficult, and, in any case, it would have had virtually no effect on the economy. The only escape is to buy more equity ETFs since it is one of the rare market segments in which the central bank is not yet a hegemonic player, owning “only” 55% of Japanese ETFs; 

2) The Bank of Japan seems to understand that there is no point in trying to devaluate the Japanese yen. Despite numerous FX interventions, QQE and QQE2, the exchange rate is increasing inexorably. Since June last year, the trade weighted JPY is up a massive 25%; 

3) The central bank recognises there is an issue of USD funding for companies that could lead to market distress in the long run. This issue is popping up at the global level, but is still undervalued by policymakers. 

The next step for the central bank will be in September, when a study on the impact of the current monetary policy program will be submitted to the government. Until then, no new measures are expected by the BoJ. The report could, however, open the door to the implementation of “helicopter money”. It could consist of issuing sovereign perpetual bonds with no maturity dates that could be purchased by the central bank. This form of monetary financing of public deficit is a last-resort measure that will certainly be as ineffective as the previous measures taken to tackle deflation (core CPI fell 0.5% y/y in June). 

For now, the ball is in the government’s court. Bolstered by its victory in July's Upper House election, and facing timid measures taken by the BoJ, the government will have no other choice than to announce a massive stimulus plan on August 2. New stimulus is expected to be around 28 trillion yen, including 13 trillion yen in spending. It could target industrial production, which was down 1.9% y/y in June, as well as low wages. The challenge for the country is to push for better coordination between monetary and fiscal policies, which could be the case if the fiscal plan to be unveiled is ambitious enough.  

Bernanke floated Japan perpetual debt idea
CEE – Russia: Poland still on the right track…for the moment

It is not all gloomy in Europe. Statistics published in July confirm that the disappointing economic growth in the first quarter 2016 was a hiccup for Poland. The economic situation remains clearly positive, driven by improving external finances and robust economic fundamentals. The decline of the unemployment rate in June from 9.1% to 8.8% partly reflects a seasonal adjustment that is completely normal at this time of the year, but also a long-term downward trend that started in 2002. Since 2007, the unemployment rate in Poland has evolved under its long-term moving average of 11.4%. It is a clear signal that the labor market is improving and will keep improving in the upcoming years. 

Private consumption remains a key driver of economic growth; consumer confidence is near its highs of 2007. The only notable downside of the economy concerns business confidence, which has evolved in a narrow range since the first quarter of 2014, well below its pre-crisis level. This translates into weak private investment. It is a key issue because it may limit long-term potential growth and result in less capital channeled towards R&D. As a consequence, Poland continues to be an economy mostly based on imitation and not on innovation. For 2016, Poland’s economic outlook is still very bright: annual growth could reach 3.2%, which is an excellent performance compared with other EU countries.

Poland: Business confidence vs consumer confidence
Nordic: Finland is Europe’s real black sheep 

From the best to worst. If there is one country in the euro area where business confidence is even lower than in Greece, it is Finland. The latest figures show that business confidence stands at -12.1 in Finland, while it is at -9.1 in Greece and -2.3 for the euro area. Finland is the perfect example of a country that has rested on its laurels and failed to bring the economy to next level innovation cycles. 

In a perfect world, the easiest way to regain competitiveness would be to devalue the currency, which has become impossible since the country adopted the euro. To complicate matters further, labor costs have been increasing by nearly 20% since 2008, while many European countries were implementing reforms precisely to lower labor cost. 

The coup de grâce came when the European Union, which Finland is part of, implemented economic sanctions against Russia, one of Finland's main export markets. Although Finland has escaped recession since 2015, economic growth remains very fragile and low business confidence level confirms a gloomy outlook. Last month's signing of a competitiveness pact between the government and the main trade unions, increasing the duration of working time, is a necessary emergency measure, but it won’t be enough to consolidate growth. Business confidence is likely to stay close to its current level in the coming months. 

Business surveys
Middle East: Getting messy and ugly for Turkey

Finally, the focus will be on Turkey for emerging markets this month. In the aftermath of the military coup, S&P downgraded Turkey one notch to BB from BB+ with a negative outlook. On August 19, Fitch Rating is due to publish its sovereign rating overview for Turkey, and will certainly downgrade the country’s credit rating, following the example of S&P. Recently, rating agencies' decisions haven’t had much mpact on economic and financial developments for most countries, but this is not the case for Turkey, which is extremely dependent on foreign financing because of low foreign reserves, low domestic savings and, above all, rising external debt.

Since the AKP came to power in 2002, external debt has increased by 120%. Political instability will have at least four main financial consequences for the country: 

1) Turkish companies' non-lira financing costs are likely to rise significantly due to the devaluation of the lira against the USD, which could reduce private investment and accentuate the bank’s credit risk; 

2) Bank profitability, which decreased by almost 55% from December 2007 to December 2015, will probably fall further, raising questions about access to liquidity; 

3) The recent strong pickup in foreign inflows is likely to reverse, intensifying market distress;

4) Promised reforms to reduce dependence on foreign financing are postponed indefinitely.

GDP growth remains above its long-term average, but downside risks have increased considerably. Slowing growth is inevitable, and could put more pressure on the central bank (whose independence is already in question) to ease monetary policy further at the upcoming meeting of August 23.

Turkey external debt vs. foreign reserves
 Source all charts: Macrobond and Saxo Bank 

— Edited by D. Deacon

Christopher Dembik is an economist with Saxo Bank in Paris


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