Sunday, 19 February 2017

Some thoughts on Europe in 2017


Germany refuses to change the status quo because the status quo suits their economic model whilst crushing the social welfare states. Germany wont give anyone a break including Greece or Brexit negotiations because it doesn't want any change. Germany needs an export surplus to the rest of the Eurozone to maintain domestic employment. As Germany switched their supply chain to East Europe they needed to increase their export surplus to southern Europe in order to maintain full employment.
But France, Italy are G8 countries that are losing manufacturing base and Greece, Spain, Portugal, Ireland have been left with high debt. UK lost manufacturing base but is now devaluing and will in my view impose tariffs under a hard Brexit.

This whole concept of 'Global Trumpism' is labour pushing back against global capital. This is now the zeitgeist in developed markets, things have changed in the last 12 months. Now the electorate is pushing back against neo-liberalism and we are seeing the age of neo-nationalism.

So in France and Italy this is labour pushing back against German exports. In Italy Beppe Grillo, an alt left candidate, and in France Le Pen, an alt right candidate, are the leaders who are driving this. On the labour vs capital debate they both say similar same things.

The only way to reverse this process of Germany taking manufacturing base is to try and reflate the German economy via sectoral (government) deficits, wage rises, push up European growth and maybe impose other structural reforms that make outsourcing more difficult. The alternative is Frexit/ Italexit etc. Frexit and Italexit I think are now unavoidable if the Germans refuse to reform.
So Le Pen is likely to win in Q2 in my view. Fillon has a financial scandal, a financial scandal involving an elite politician and government funds is exactly the wrong type of scandal in this political environment. Even if Fillon wins he has to ask Europe for reform. So the question for financial markets is whether the French electorate empower Le Pen to drive changes or Fillon. I now think that they will empower Le Pen. Her platform is to call a Frexit vote.

If she calls a Frexit vote for say September/ October 2017, you have stress guaranteed in Europe into that. The German elections are in August, so its unlikely any substantive discussions could happen before that. Europe will be facing an existential crisis that will be resolved by a narrow referendum vote. Similar votes (Brexit, Italian referendum, Trump have all gone for labour and against global capital). There has to be a market stress into that. If you think about where yields in Europe were in 2011 or 2012 there can be large repricings, irregardless of ECB buying. In any case there are many European assets the ECB is not buying.

My bet would be that France narrowly votes against Frexit, but then Le Pen goes to Brussels and demands reforms into year end. If she doesnt get the substantive reforms she calls another Frexit vote and this second time the French vote to leave, followed by Italy.

If she gets pro reflation, pro growth reforms then Europe rallies, afterwards. But before that I think we need European stress. It will take a crisis to force the Germans and east Europeans to agree. If she does not get reform then I think France and Italy leave the Eurozone, at which point the European project is in tatters. Germany will be the only net contributor in size after the UK and France leave... As such I think Germany has to cave in, but it takes a real crisis to force that.

That is my current view on Europe this year, just my personal opinion. It could prove to be an exciting year in the European political economy.

As a corollary, with extreme current speculative positioning, the problem with being short US bonds now is if there is a EZ crisis then US fixed income should counter-trend rally; medium term though I am sure that the US belly needs to price in 4-5% nominal GDP rates vs a Fed that is behind the curve, but slowly hiking.

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