Macro outlook: ‘into the summer lull’

Ahead of summer lull, central bank confusion leads to fresh equity selloff but, in the medium term, macroeconomics and earnings remain supportive of the market.

The first part of the year was finally more quiet than expected. Political risk had a little impact on the developed world, contrary to what happened in 2016.

Europe is catching up

2017 YTD total returns for the European stock market reach 17 percent versus 18 percent for Emerging Markets and 8.8 percent for the United States. Financial stress remains quite low. BofA Merrill Lynch Global Financial Stress Index and Markit iTraxx Europe Senior Financial Index (which tracks stress on the European banking sector) are close to their two-year low. In addition, CAPEX were very solid in Europe in Q1 2017 and should keep improving in the next sixth month, based on economic expectations.

Greece is off the radar (for the moment)

The release of a new loan tranche of 8.5 billion euros will enable Greece to repay its creditors in July for a total of 6.24 billion euros (including 2.4 billion euros to the ECB and 0.2 billion euros to the IMF). Like many current economic issue, the Greek debt relief is postponed after the German election. A haircut of at least one third of the debt is economically necessary for Greece but politically delicate.

Christopher Dembik, head of Macro Analysis, Saxo Bank

Before discussing this issue, it is likely that the Franco-German couple will push in 2018 for an extension of the Greek debt maturities. This solution would be politically consensual since it would cost nothing to the creditor countries. Indeed, in the case of bilateral loans, the postponement of interest rates payments is considered as additional loans, with means that Greece will later pay them with additional interest payments on them.

As far as the loans of the EFSF are concerned, Greece pays a higher interest rate than the interest rate at which the EFSF borrowed the funds. Therefore, extending the duration would have a neutral effect on the lending countries but, as a matter of fact, it would not be enough for Greece to get back on track.

France is back

What we call the ‘Macron effect’ will certainly vanish in the next three months. The expected labor market revolution has not materialized. The reform, which has been recently unveiled, consists essentially in a simplification of the labor code aiming to reduce legal insecurity for entrepreneurs and in a flexibilization of the employment contract with the extension of the “mission contract” to other sectors than construction.

Unlike fixed-term contracts where the termination is known from the beginning, this next contract expires only when the project is done, which give the employer more flexibility. Until now, it was mainly used in the construction sector to deal with site delays.

France has no choice but to succeed in reforming the labor market, which was one of the key reforms strongly suggested by the EC in its last recommendation, if it does not want to be sanctioned by the European authorities for excessive deficit. That’s the deal. The EC can temporary turn a blind eye on France’s public finances on the condition that structural reforms are implemented. Unsurprisingly, the country is not expected to meet its deficit target set at 2.8 percent of GDP this year.

It should be around 3.2 percent, at best three percent if spending cuts are quickly decided. France is back but remains Europe’s ugly duckling. Since 1999, the country has been 13 years in violation of the 3 percent deficit / GDP criterion versus nine years for Italy, 7 years for Germany and only 1 year for Denmark according to the WEO.

Since the GFC, there is no quiet summer for investors. However, risk seems quite limited for July and August.

Political risk and oil

As almost every year, oil prices and political risk are likely to spur volatility in the markets. The main risk currently perceived concerns new tensions between the United States and North Korea after the death of the U.S. citizen Otto Warmbier (after being imprisoned in North Korea for 18 months). Few days after, in reaction, China decided to suspend fuel sales to North Korea.

As a result of the country’s energy dependence on supplies made by the China National Petroleum Corp, the suspension could have a very negative impact on North Korea’s fragile economy. It is not the first time that Beijing has decided economic sanctions against its neighbor. It halted coal purchases this year after Kim’s estranged half-brother was murdered in Malaysia. Increasingly isolated, the North Korean regime could be tempted to escalate tensions by carrying out a new missile test. Such an event could also be the way for Donald Trump to revive its image at home which was wracked by his inability to implement the economic reforms promised during the electoral campaign.

Jackson Hole Annual Symposium

Recent central bank confusion could also create volatility throughout the summer. In this context, the 2017 Economic Symposium organized by the Federal Reserve of Kansas City will be of crucial importance as it could help clarify the intentions of central bankers ahead of the monetary policy meetings of September. This year’s theme will be perfectly in line with current events: “Fostering a Dynamic Global Economy”. Last year, at the occasion of the Symposium, Janet Yellen sent a strong signal to the markets that the U.S. central bank is preparing to increase rates. In light of Yellen’s latest comments, the U.S. slowdown should not jeopardize the ongoing process of rate normalization.

No future for Schulz

Social democracy is in crisis mode in many European countries. In Germany, the Schulz effect did not last long. Since the beginning of the year, the SPD has suffered three bitter defeats against the CDU in Saarland, Schleswig-Holstein and North Rhine-Westphalia. This last state, which is Germany’s most populous one, was governed by SPD for all but five of the past 50 years and is Schulz’s home state. Based on those results, it is likely that the general election will lead to a clear victory of the CDU/CSU (40 percent of voting intentions in the latest polls versus 25 percent for the SPD) and could form a coalition government with the FDP (around 9.5 percent of voting intentions).

Officially, the SPD still believes in a last-minute comeback as when Schroder managed to gain 20 points in the last few weeks ahead of the vote, but this scenario seems very unlikely unless a series of missteps committed by Merkel happen. A CDU/CSU/FDP alliance could lead to a tougher position vis-à-vis Greece, particularly with regards to the 3.5 percent primary surplus target through 2022, which is complete economic illiteracy when unemployment is above 20 percent.

At the domestic level, the challenges remind of the twelve labors of Hercules. Germany has its strengths such as its low unemployment and its excellent credit rating but, fundamentally, Germany’s economy is dysfunctional. Its massive current-account surplus, which is praised by policymakers as a characteristic of high competitiveness, is also the sign that local businesses are unwilling to invest in the country. According to the IMF, the country has the lowest investment rate of any developed economy. Since 2005, Merkel has barely delivered on economic reform; she has mostly managed the legacy of Schroder and Hartz.

Over the past seven years, Germany is the developed country that has done the least amount of pro-growth reforms according to the OECD. As a result, Germany languishes in 114th place globally for ease of starting a business versus 56th place for Greece and 27th place for France. In addition, average annual productivity growth over the past decade, reaching only 0.7 percent, has been slower even than Portugal’s (0.9 percent) and Spain’s (1.2 percent). To defend his lead, Germany will have to accelerate the pace of reforms which means boosting productivity, reinvesting the current-account surplus, and paying fairly workers their due.