Catalonia

Spain’s Prime Minister Mariano Rajoy just achieved what many thought impossible having in just twenty four hours succeeded in putting Brexit on the back-burner on the ‘list of things to worry about,’ for the EU. His heavy handed and insensitive approach to yesterday’s referendum has put succession tension in the region on the world’s front pages and will have unquestionably strengthened local resolve and pushed many ‘no,’ voters across to the independence camp simply out of family and community loyalty.

Images of ordinary decent citizens being beaten up by para military police are shocking. These weren’t the usual protesting unwashed anarchists we are used to seeing ripping up paving stones at G7 summits. They were mothers and fathers, aunts and uncles, brothers and sisters who were simply out and about with the intention of casting a vote. Rajoy has blown it and there will be consequences beyond Catalonia.

A positive vote with a convincing turnout was always a low probability event but Rajoy now has a simmering feud on his hands which will be a persistent and long lasting issue for future successive Spanish governments. And let’s not be naive here. The separatists managed to manoeuvre the national government into a no-win situation by refusing to engage and offering no optionality forcing the government down a path of action which would have negative repercussions across the worlds press. Of course, the federal police agencies weren’t forced into their heavy-handed actions. That simply amplified the impression that normal people are being denied their democratic rights. Moreover, the reported 42.3% turnout lacks legitimacy even if 90% of the votes were in favour of separatism. Legislation for the vote was only passed 4 weeks ago and opponents of independence simply refused to debate or engage in any meaningful way. The referendum was held in a manner that would not pass any independent audit with separatist movements issuing their own ballot papers and the local government suggesting that voters even download their ballot papers from a Catalonian government website.  

Prime Minister Rajoy’s credibility though is shot to pieces. Rajoy anyway relies on minority parties to help him with his legislative programme in parliament and some of those may be less well disposed to sit in his corner. The problem for the EU is that this comes at a time when many national governments in Europe, including Spain, have minority governments and with Merkel struggling to form a coalition there is a striking lack of leadership across the EU with the possible exception of France where of course Macron is flying into strong headwinds of his own with his reform programme.

I have consistently repeated two views regarding the EU and Brexit. First, that we are better off out because the whole monstrous construct is structurally flawed and will anyway, implode at some future point because of accelerating national divides, (watch the trend in popularism infect Eastern Europe, Belgium and Italy in the months ahead), and economic disparity between north and south. Second, that whilst an advocate of Brexit my long-held concern is that Westminster lacks the expertise, experience and wisdom, both politically and within the civil service to ensure a smooth and elegant exit. Funny how both are manifesting themselves simeoultaenously. 

Slight Flaw in the Budget

Phillip Hammond delivered a reassuringly dull budget this week. The furore over the self-employed will pass or be diluted. Just what investors like to see. In fact, Hammond holds many of the traits fund managers like to see in CEO’s; ‘reassuringly dull,’ covers it nicely. Mr Hammond said that according to the OBR borrowing will be less than predicted that borrowing will be £51.7bn in 16-17, down from the predicted £68.2bn. The Chancellor has promised in fact to drop the deficit below 2% by 2021 and eliminate it completely shortly thereafter.

That would take nothing short of a miracle.

Britain’s national income has exceeded expenses expressed as a percentage of GDP for just two brief moments in the last 30 years. The first followed the stock market’s mid-80’s surge and the second was in the final stages of the Tech boom in the late 90’s. The market peaked shortly thereafter turning the surplus into a big deficit. The financial condition of the UK has been deteriorating for decades now. A 1.5% budget surplus in 2000 reversed before it reached its ’87 peak of 2% in 1988. The budget gap wasn’t closed at all in 2007 prior to the financial crisis despite booming stock and property markets. The subsequent 2008-9 deficit beat all previous records. In terms of debt to GDP, UK debt in 2010 was the third highest in the world being beaten only by Greece and Italy.

This is probably as good as it gets. The living-in-fairyland inhabitants of Westminster moan without pause about austerity. They are in for a shock. Mr Hammond’s positive read on government finances is not a ramp for take-off; it is a warning that the edge is near.

Europe; Coming Unglued

The financial media have, as usual, been watching a different movie.

The financial media have, as usual, been watching a different movie.

A friend recently said in reply to a comment, 'I think we're going to hell in a basket.' She is probably right but not for the reasons she thinks. My friend was referring to the consequences of Brexit. I am referring to the structural issues which are baked into the Eurozone and which are coming unwound at a pace which is very likely to accelerate throughout 2017. Standing close to an exploding bomb is never a good idea. The further away we are the better although it will take more than the English Channel and the political aspiration, if not commitment to leave, to save us from at least some of the backblast.

Political risk in Europe appears to be growing. The truth is, it never went away. It was simply subdued temporarily by successive ECB bailouts which have rescued (some) ailing banks but have done nothing to correct the systemic flaws in the Euro which have ruined southern European economies. Now, as political risk takes front and centre stage with Le Pen soaring in the polls the underlying economic risks which have been fermenting for years are at risk of ripping loose. The means of transmission are again, most likely to be the banks. You see, nothing has really changed.

We saw during the last period of Euro stress in 2011-12 that a sell off in bonds hit the balance sheets of European banks who tend to hold their own governments debt which increased their need for bailouts. In turn, that hits depositor and investor confidence which damage the banks even more creating a death spiral requiring direct central government intervention. As you may have guessed, the three countries with the banking sector most exposed to their own governments debt are Italy, Spain and Portugal.

With the ECB scaling back its bond purchases and the rising incidence of inflation yields have been rising. More importantly, spreads have been widening reflecting growing risk between member states.

Markets have so far placed a low delta on a Le Pen victory in France. Markets are being naïve. The French electoral system is designed to keep the door firmly shut against extremist parties but with the other candidates carrying baggage of their own her defeat is far from certain. Italy’s election meanwhile could result in a government under the influence of the Five Star Movement of the Northern League, both of which are committed to leaving the EU. Markets would not wait for an EU referendum result in these countries. Merely scheduling one will result in financial chaos. Meanwhile another Greek crisis similar to 2015 looks baked in when they run out of money in July.

Investors are hardened to serial crisis in these countries but are broadly complacent in their thinking that after a lot of fuss there will be another bailout and normal business will resume. Italy’s banks still hold 276bn in bad loans and the countries debt to GDP ratio stands at 134%. With 12% of the country’s bank assets being held in national debt there is a financial death spiral just waiting to be triggered. A small issue here is that Italy is the third biggest economy in the Euro block. That won’t be an easy fix.

Portugal meanwhile is back where it started with debt as high as it was in 2010. The 78bn Euro bailout there did not reverse economic trends. It did though, save the banks, for now.

The ever sensible and cautious Germans have been trying for years to neutralise this threat, first with a proposal to limit the amount of domestic sovereign debt that a bank could own. Germany failed. The second German proposal was adopted. That was to require that bank bond holders take a draw down, to zero if necessary, before government money could be used to bail out. Unfortunately, when Banca Monti Dei Paschi ran onto the rocks in December the rules were bent out of shape by using out of date stress tests and reimbursing debtholders saying they had been misled. That prevented a political fuss in Italy but has left the potential financial death spiral in place.

Other ideas, mostly based on the ‘bad bank,’ approach have circulated in recent years and include creating two classes of bonds, pooled together from the Eurozone countries, and divided into ‘safe,’ and lets call it ‘less safe.’ Loosely, that would be Germany plus one or two other countries and the rest. Unfortunately, the Germans are not big fans of either of these plans or any of their derivatives. The Germans in fact have been playing a quite crafty and streetwise game and who could blame them. German banks have pulled back their lending to non-German companies in the Eurozone over the past few years. Their appetite for shared risk is diminishing and the banks preference for keeping their money inside their national borders reflects this.

Germany itself has its own handcart of problems. Germany will of course work hard to keep the Eurozone together but it is not without its critics from both within and from outside. Germany is under constant criticism for having the largest trade surplus in the world, something that has not gone unnoticed by the Trump administration. It is ironic that Germany is the most powerful member of the very institutions that were imposed upon it in post war Europe. Indeed, the Euro was created years later in part to tie a reunified Germany to France and losing the Mark was the price paid for reunification. The trade off for Southern Europe in being unable to devalue was access to Northern European borrowing rates which allowed much needed structural reforms to be put firmly on the back burner.

Monetary union with fiscal union blocked potential wealth distributing mechanisms and acceptance of risk sharing required Southern Europe to gift their fiscal policies to Brussels. The Eurozone crisis and subsequent austerity measures have created fertile ground for growing resentment which has fanned the flames of populist movements which are gaining traction across the Eurozone. The refugee crisis and local political scandals have poured kerosene on an already politically volatile state. Growing recent civil unrest in France, (not much reported in the UK), and less violent demonstrations in Germany, reflect the heightened political volatility.

Political and economic structural tensions in Europe will continue to rise across the Continent in the coming months. They may well be contained and then abate. Protectionist rhetoric from Washington however complicates matters somewhat and are anathema to Germany’s export led economy. How the global economy, which has been designed and built around the free movement of people, goods and services reacts to fundamental changes driven by Washington remains an open question. Certainly, a much stronger dollar would be deflationary and wipe out the glimpses of inflation we are now seeing and that has a world of implications starting with Emerging markets and the $9tr of foreign dollar denominated loans which are ticking away.

With, for the moment, inflation at the gates and with bond yields rising in France and the periphery, the increased cost of debt repayments will do nothing to stabilise matters. Equities meanwhile have been skipping along without a care in the world. They may be about to stumble. For what it is worth, I firmly believe that the whole rotten construct is closer than most believe to coming completely unglued. Let’s hope that the financial boffins at the Bank of England are earning their money and are stress testing the banking and clearing system to destruction. It won’t be so very long before risk managers across the City are once again obsessed with counter party risk.

As a quiet postscript, those investment banks such as HSBC and Morgan Stanley who are making noises about moving some staff to Frankfurt and Paris, good luck. You are going to very much need it.