The Markets and the Long Shadow of Politics

Why should we think there is anything
amiss by looking at the global capital markets? 
 The S&P 500 and the German Dax
are at record levels.  The Japanese market is at 20-year highs.  The
MSCI Emerging Equity Index moved higher every month this year through
August.  It slipped a little more than 0.5% in September but is up 4% in the first half of this month.  
Aren’t interest rates low,
despite trend or better growth in the US, EU and Japan?
  The BRICs are expanding.  The
IMF revised up its global growth forecasts.  Although lowflation remains a
significant concern for central bankers, deflationary forces appear to have
been arrested.  There are an estimated $3 trillion of debt still offering
negative interest rates.  The US benchmark 10-year yield has turned back
from the 2.40% area as it has done a few other times over the past six months.  
The 10-year German Bund
yield is capped at 50 bp.
  It did spend some time above there
in July and August and flirted with it
again in late September and early October, but it is now testing the lower end
of its recent range near 40 bp.  A trendline is drawn off the last time the Bund yield was below zero, October
2016, and off this year’s April, June and
September lows comes in now near 33 bp.  
The persistent dollar
strength seen from the middle of 2014 through the start of the is the year, faded this year. 
 The dollar’s strength was a factor
cited behind the recent disappointing inflation readings.  Although the
foreign exchange market has not been a major source of stress for officials,
there does seem to be some effort to talk it down when it has strayed above $1.20.  
We suspect that infatuation
with the so-called cyber currencies, which have little in common with what we know as money, and even fiat money at
that, is partly driven by the same underlying factor as other financial assets.
  There is too much capital
relative to the demand by industry and much of the surplus capital that is not simply wasted gets circulated in
financial assets.  
Moreover, companies used to
be the net borrower of capital, and now they are net suppliers.
  US, Japanese, and European
corporates are sitting with an estimated $7-$8 trillion of cash and cash
equivalents on their balance sheets.  Since the early 2000s, when US laws were
changed to exempt share buybacks from stock manipulation rules, US
companies have bought by an estimated $7 trillion of their shares.  
One of the developments this
year has been the stepped-up corporate buybacks of their debt.
  According to Bloomberg data,
through the end of September, S&P 500 companies have bought back nearly
$180 bln of their bonds after a little more than $87 bln all of the last year.
Leave aside the lessons that
Minsky taught, and many of us had to
re-learn during the Great Financial Crisis, that financial stability itself
leads to its opposite, through financial engineering, leverage, and mispricing of risk.
  Leave aside that the spread between
the Russell 1000 Value Index and the Russell 1000 Growth Index is the widest
since the end of the tech bubble in 2000. 
The immediate problem is that the rewards of the market economy and
appreciating asset prices benefit the few, and, in various forms and numerous ways, the response has become a
potent political force.
Indeed with the arguable exception of the UK, which publishes
its latest CPI, retail sales, and employment reports, politics dominate the
agenda next week and in the run-up to the ECB meeting on October 26. 
  The market has gone as far
toward pricing in a December rate hike as seem prudent at this juncture. 
It peaked as we surmised after the September employment report.  Six Fed
officials speak in the week ahead.  Yellen and Dudley’s comments are the most important, but investors should not
expect more insight into the December meeting, and we would pencil in zero
chance of a November hike.  
In terms of politics, Europe dominates the first part
of the week, and Asia the second part. 
 The US political drama runs throughout. 
Executive orders to stop subsidizing insurance companies under the Affordable
Care Act given the failure of Republicans to “reform and
replace”  it creates the potential
for greater disruption.  Several states are apparently poised to challenge
the President’s order in the judiciary.  Tax reform may be running aground
after Trump said last week that he would
make some adjustments shortly to the framework offered last month.  There
has been a significant resistance to abolishing the state and local tax (SALT)
deduction (from Federal tax obligations).  
Recall that the Border Tax
Adjustment was to raise $1 trillion over the next decade.
  Health care reform was to raise
another $1 trillion.  The end of the SALT deduction was to raise $1.5
trillion.  If these revenues are no longer likely, what will be replacing them?  Can the resulting
deficit be assumed away if we forecast sufficient faster growth, spurred by the
tax cuts themselves?  
Trump’s nomination of the
next Federal Reserve Chair is expected
any day.
  Surveys of
market participants see Warsh as most likely to get the nod while betting websites see
Powell as more likely.  Reports suggest that Treasury Secretary Mnuchin
prefers Powell.   This takes an
unnecessary risk of clout if not credibility if Trump picks someone
else.  
European politic anxiety has
increased, not lessened as expected, since the German election.
  Spain’s largest constitutional
crisis in a generation is winding down.  Puigdemont’s secessionist play
failed.  There was no international support.  The elite, political,
economic and royal, showed a common front.  Nor was Puigdemont successful
in helping topple Rajoy’s minority government.  
Instead, Puigdemont danced
around:  declaring and suspending independence. Madrid is the not the only
one calling for a clear, unambiguous
statement.
  The
far-left party in his regional government alliance has threatened to withdraw
support from Puigdemont, which would likely trigger a new regional election unless he declares
independence.  
Austria holds an election on October  15.  The political spectrum in Austria
has shifted to the right.  Even the Social Democrats supported abolishing
Muslim pre-schools because it created
separate societies.  The populist-nationalist Freedom Party has been
polling in second place with about one in four voters.  
The Popular Party poised to
record a plurality of votes has already adopted much of the Freedom’s Party’s
anti-immigrant and anti-Muslim stance.
  The last time the Freedom Party was part of the Austrian
government, many other European countries ostracized it.  It will be
interesting to see what happens, though we suspect a different response this
time.  
Italy’s approved a new
electoral reform bill, which appears to have few bells and whistles and does
not include a bonus number of seats for a party
with the most votes.
 
It rewards pre-election coalitions.  This
is to the detriment of the populist-nationalist Five-Star Movement, which rules
out such coalitions.  It seems to be a small step toward addressing the
fragmentation of Italy’s politics.  It may still be short of creating majority parties, but the
coalitions may consist of large blocs.  
Ideas of an election this
year, or even in Q1 next year, may be exaggerated
.  The electoral law needs to be debated and approved by the Senate. 
More pressing is the 2018 budget.  That will take the next several
weeks.  Then there is Berlusconi, who has challenged being barred from running for office.  It is not immediately clear if Berlusconi indeed wants to run for office again.  Still, it would make sense that Berlusconi and his allies seek to delay an election until
the European judicial decision is handed down, and that may not be until next
year.  
Turning to Asia-Pacific, New
Zealand held elections last month.
  New Zealand First support is needed to form the next
government.  Although the ideological affinity is with the governing
Nationals, pragmatic consideration, like the deal that can be arranged, may be more important.  
An announcement is expected at the start of the new week. A center-right government would
appear to be what the market is anticipating.  The New Zealand dollar
carved a bottom below $0.7000 in the first
part of last week, from which it launched
an assault on $0.7200 before the end of the week.  This is an important technical area that contains the 20-day moving
average and a retracement objective of the election-related leg down since
September 20.  The technical indicators are consistent with additional
gains, though the $0.7240-$0.7300 may restrain the upside initially.
The 19th Chinese Communist
Party Congress begins the middle of the week.  
For political theater, it may be more
nuanced for investors’ palate for the dramatic may find very interesting. 
It seems widely recognized as a showcase for President Xi’s power, which as a
recognized “core leader” may be the most since Deng Xiaoping. 
 For investment opportunities, the Congress may also be light.  
However, the impact could be
indirect.
  If one
believes the not very whispered whispers that Chinese officials have ordered
and engineered great stability ahead of the Congress, then some increase in
volatility should be expected.  Chinese stocks have lagged most other
markets, but recent gains Shanghai have lifted the Composite to its best levels
since March 2016. The Shanghai Composite has risen in four of the past five
quarters.  The 4%+ gain in Q3 was the largest since Q4 15, during the
bubble.  
The week after the Party
Congress ends, China’s government is expected to sell dollar bonds for the
first time in more than a decade. 
 The small amount ($2 bln) that is expected to be raised is a little importance to China, and
will likely be priced tightly, helped by novelty and scarcity
considerations.  It may provide a benchmark for other dollar borrowers,
like businesses.  What is striking is that this offering, which could be
the first of many, it seems to be another testament to the resilience of the
dollar standard.  
China’s offering is
emblematic of developing countries demand. 
 According to figures in the Wall
Street Journal, private and public sector dollar borrowings from emerging
market countries, this year alone is in excess of $500 bln, a new record.  The
BIS estimates that total dollar debt owed by non-US government and businesses
at $10.7 trillion, of which $3.7 trillion is
accounted for by emerging markets.  
Japan goes to the polls on
October 22.
  The
main question now is whether the LDP and its Komeito Party ally will retain
their super-majority.  The Party of Hope is not running enough candidates
to win a majority of the seat.  Polls suggest it has lost some
momentum.  There appears to be some infighting, according to
reports.  There will be 465 seats in the next Diet.  The governing
coalition needs to win 307 seats to retain its 2/3 majority.  
Under what conditions could
Abe feel compelled to step down?
  We suspect that nothing shy of not being able to marshal a majority coalition would push Abe out
of office.  It is possible that a defeat in which the LDP itself fails to
win an outright majority may spur a leadership challenge this time next year,
Abe would likely to retain office. 
 
The two big policy issues
that the Party of Hope has staked out is the phasing out of nuclear power
entirely and abolishing the retail sales tax hike planned for 2019.
  It is not clear, at this juncture,
that Abe can co-opt either issue.  A cabinet reshuffle after the election
seems only natural.  Here there may be an opportunity to steal some
thunder of the Party of Hope and further expand on Abe’s third arrow through
the power of appointment to the cabinet. 
The UK, which reports important economic data,
is also subject to political considerations. 
 The EU’s Barnier’s claim that Brexit
talks are deadlocked means that the heads
of state (EU Council), which meet at the end of next week, are unlikely to
overrule their chief negotiator.  That means that the familiar issues,
like the exit bill, Northern Ireland’s border, and citizens’ rights will
continue to be discussed.  If
“sufficient”  progress is made,
December is the next window of opportunity to shift the talks to the new relationship
and trade.
Ahead of the inflation,
retail sales and labor market reports, the market is discounting more than a
75% chance of a rate hike next month.
  BOE Governor Carney has not wavered in his assessment that
a rate hike may be necessary for the
coming months.  Speculators in the futures market, a proxy for trend
followers and momentum players, are net long 15.5k sterling contracts.  As
recently as early September, they were net short 53k contracts.  
The Bloomberg survey finds a
median of respondents expect inflation to tick
up.
  However,
average weekly pay is not likely to rise,
and retail sales are expected to have softened.  Separately, the BOE
reported last week that UK banks had
tightened credit for unsecured borrowing, and annual growth in consumer credit
slowed below 10% for the first time since April 2016.  
Market positioning suggests the reaction may be more dramatic to
disappointment, especially anything that would justify waiting an extra month
before hiking rates.
 
Many economists still expect UK inflation to peak here in Q4, while the economy
continues to gradually slow.  The expansion is likely slowing a the
third consecutive year.  

Disclaimer

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