24 Feb Inflating European Expectations

The Wall Street Journal reported yesterday that for the first time in almost 4 years none of the Eurozone’s 19 member countries was in deflation during January.  Aggregate Inflation across the region is now 1.8%, approaching the ECB’s target of 2.0%.  The data is a notable marker that may be the signal for the ultra-accommodative ECB to reign in its QE program a little over two years since the Fed ended QE3 in the fall of 2015.  Such a move would have a profound effect on European currency rates with the U.S.  Fund flows follow real interest rates over the long-term.  With real interest rates higher in the U.S. than almost any Developed economy it is a no brainer that money should flow into the dollar.  As the fed began raising rates at the end of 2015 it is no surprise that European currencies correspondingly declined substantially over the course of last year. The Fed’s most recent hike has put further pressure on the value of GBP, EURO, CHF and Kroners. 

Enter the natural beauty of self-correcting global economics.  Between 2011 and 2015 global fx markets were mind numbingly boring.  During, what on the surface, appeared as a turbulent period in global economic history Sterling and the Euro traded within a very narrow range with the USD.   With virtually all central banks aligned behind hugely stimulate actions, transatlantic currencies traded largely in unison.  In such circumstances with the US ahead of the curve in terms of post crisis economic recovery the competitive advantage lay in North America.  The turn in Fed policy at the end of 2015 broke that trend and 2016 served as a corrective year in terms of currency equalization. 

The downdraft in European currency valuations has had the twin effect of boosting Europe’s competitive position and pushing up inflation as import prices increased.  European markets have quietly taken note.  Despite European equity performance in dollar terms once again falling behind U.S. in 2016, in local terms European equities had a strong year with aggregate performance reaching high single digits.  For U.S. based investors the benefits of increasing exposure to Europe are sweetened by the weak currencies and the opportunity to shop around for stock at attractive discounts.  Wow, even a Big Mac in London is now 6% cheaper than the U.S., in London! 

In the post crisis-era international markets have morphed into risk-on trades.  Despite positive U.S. based market returns, investors have remained jittery in recent years preferring assurance over risk.  As global economic growth increases and a reflation trade gets underway the irony of a successful Trump economy could very likely be that international markets begin to outperform as risk appetite re-emerges and investors seek higher returns at reasonable valuations–sounds like Europe to me. 

14 Nov Election Tea Leaves

A global grass roots political upheaval is spreading. Brazil has ousted its president and Venezuela is an inch away. Brexit was a core “no more” vote against immigration. The U.S. was a surprise double header with Republicans taking both the White House and the Congress. France seems certain to change and even Mrs. Merkel is under attack. A growing faction of the democratic electorate feel disenfranchised and restive with their governments’ policies either making inroads on their everyday lives or leaving them economically disadvantaged. Well intentioned legislation such as health care for the poor or regional trade agreements are viewed as being poorly planned and executed, or damaging to jobs. Government is seen as exercising excessive power and not understanding the consequences. Voters are drawing a line in the sand and ousting those in power or rejecting anointed successors.

Since World War II there have been 18 U.S. presidential elections. Each has had its unique characteristics although often economic conditions or international problems were the controlling determinants. The 2016 election was an outlier as unemployment and inflation were low and we only had an arms’ length involvement in the Middle East. The candidates personalities and backgrounds were the focal points and issues seemed an afterthought. In some respects, there were similarities to the 1980 Jimmy Carter – Ronald Reagan campaign. Carter was pro government while Reagan was anti-government and wanted to reduce taxes. Reagan was a much different personality than Trump but they shared a belief in the Laffer curve (cut taxes and the GDP will grow faster) and the need to build defense. Reagan won by a big margin but interestingly his critics viewed him as a mediocre actor and not fit to be president. The dollar started a sharp long term advance the day he was elected. Tax cuts were enacted in 1981 and the stock market which had been suffering from inflation, high interest rates, and a recession jumped in August 1982 on its way to a multi-year advance.

Rarely has the country elected a President like Trump with strong controversial positions on several key issues. However, it should be remembered politics has long been characterized as “the art of compromise”. The President Elect has a challenge in front of him to deal with a Republican Congress that has many disparate views and priorities. They are generally on the same page regarding corporate tax reduction, changing Obama care, supporting infrastructure spending, bolstering military outlays, revising Dodd-Frank, reducing government regulation, and appointing conservatives to the Supreme Court. Less clear is their willingness and ability to resolve multi-faceted perspectives on immigration, trade, climate, entitlements and personal taxes and picking up some Democratic support along the way.

In the three trading sessions following November 8, the market has already voted for higher interest rates, less bank reform, higher infrastructure spending, more military support, lower corporate taxes, reduced penalties for recouping corporate cash abroad, reducing payments for hospital services and no price controls on drugs. Higher interest costs will certainly hurt the federal budget. Even the advocates for tax cuts acknowledge the deficit will grow in the first few years. The tidal shift from stocks to bonds looks to be over. The S&P 500 effective tax rate is expected to decline from 27% to 20% which would put 2017 earnings at about $133.00 per share if the rate was in place for the year. Early predictions are for the change to occur mid-year. However, the market rarely awards higher valuations for one time tax declines and especially when they are accompanied with higher interest rates. Higher stock index prices clearly rest on better economic growth. New opportunities will be best found in the shifting landscape among sectors and industries.