While major stock markets and commodities prices have risen on higher expectations for growth since the US elections on November 8, emerging markets continue to weaken.
Long-term inflation expectations have picked up from their lows in mid-2016, but still remain very low compared to the long-term averages. Optimism about the world economy in the aftermath of the US elections has somewhat improved, but the improvement is modest and uneven.
The sharp rise in the US dollar trade-weighted index puts pressure on economies with large amounts of external debt. Italy is a significant concern. During the European financial crisis of 2011-2013, Italian government bond yields exceeded German yields by more than 5%.
Since Italy’s government debt stands at about 130% of GDP, that is the equivalent of an additional 6.5% of GDP in government debt service. Since 2014 the spread between Italian and German debt has traded in the range of 1%-2%, but it is now close to the wide end of that range. If it were to break out, Italy would have major financial problems.
Italy must deal with a solvency problem in its banking system (where non-performing loans are about a fifth of total loans). Despite European Commission rules to the contrary, Italy probably will intervene to bail out its banks because retail investors hold about 237 billion euros worth of bank bonds, and a bail-in for retail investors would cause political uproar.
Italian bank stocks fell sharply last week as efforts to sell Italian non-performing loans (NPLs) in the form of credit structure ran into trouble. The trouble is that Italian banks have been bailing out the sovereign (they own 22% of all sovereign debt), and if the sovereign has to bail out the banks, who will bail out the sovereign?
Prime Minister Matteo Renzi has staked his political career on victory in a constitutional referendum on December 4, which he now seems likely to lose. That will lead to a political vacuum in which banking risk may be priced much more prejudicially.
Participants did not believe that the widening of Italian spread to Bunds was due to political changes in Italy, though, but rather due to the global environment.
More threatening to Italy’s outlook than the December 4 referendum may be the December 8 meeting of the European Central Bank, which may impose a six-month phase-out of quantitative easing and thus reduce official demand for government debt.
The Italian government is also concerned about the possibility that the European Commission may demand a fiscal adjustment to reduce Italy’s budget deficit, which is now well in excess of commission guidelines. It is also concerned about the migrant crisis, which has shifted from the borders of European countries to the Mediterranean route.
If Renzi loses the referendum, he will attempt to leave the premiership, while his opponents will try to force him to stay and take the blame for the messy consequences. That does not portend well for confidence in Italy’s government.
The group continued to voice concern about the May 2017 presidential election first round in France. The National Front is likely to poll higher than either the center-right, which has no widely popular candidate, or the Socialists, given that President Francois Hollande’s approval rating has fallen to 4%.
Ultimately the left and center-right will unite to keep National Front candidate Marine Le Pen out of the presidency, but the non-zero probability of a populist government in France will have the country in turmoil for some months.
Given the delicacy of the political situation, several participants expected European central banks to postpone the imposition of new capital and liquidity rules for European banks. Starting next year European banks will be required to hold more liquid assets, and in 2018 new capital rules under the Bank for International Settlements will come into effect. Few European banks are prepared for the more stringent regime and the path of least resistance is to abandon it.
Emerging markets remain a concern. As some participants emphasized last week, the doubling of emerging market foreign currency debt and the rise in industrial nations’ sovereign yields reduce the attractiveness of emerging market obligations and may make debt servicing more difficult in the future. This is particularly worrying given zero or negative world trade growth.
Chinese President Xi Jinping’s speech at the APEC summit in Lima was noteworthy in this respect, calling for a new trans-Pacific free trade zone. In the past, the world criticized China for protectionism; now the inhibition to the free flow of goods and ideas is coming from elsewhere, notably the one-time free-trade champion, the US.
China, Xi added, is committed to absorbing US$8 trillion of imports during the next five years and will provide US$750 billion in overseas direct investment (the latter being a conservative number as China ODI in 2016 could exceed US$170 billion). We expect Latin American countries to scramble to reorient their economic relationships towards China, a tendency long in preparation.
Three situations are of particular concern.
Mexico has suffered the most drastic devaluation in the emerging market universe, and ratings agencies are likely to downgrade its debt. There is the risk of a vicious cycle of currency depreciation, rising interest rates and higher debt servicing costs. The decline of Mexico’s peso is particularly alarming. Mexico has had to raise interest rates (to an overnight rate of 5.25% last week) to slow the decline of the peso. Foreign direct investment in Mexico as well as workers’ remittances are at risk.
India’s bank note reform produced unintended consequences. The Indian government evidently underestimated the size of the informal economy. Rather than the 25% that the government estimated, the parallel economy probably accounts for 35% of India’s economic activity. The demonetization of large-denomination banknotes – 500 and 1,000 rupees – has already caused a crash in the residential property market, with high-end properties offered at 40% below their level prior to the reform.
The tax windfall for the government will probably be in the range of US$70 billion to US$75 billion. This tax shock to the economy will suppress growth in the short run and will have unpredictable consequences, since so many economic agents have been partially expropriated.
South Korea’s political crisis is a second concern. Millions of demonstrators have taken to the streets in downtown Seoul since the corruption scandal in the administration of President Park Geun-hye, broke. Korean prosecutors now claim that Park was cognizant of the corruption. If the Korean Chaebol are drawn into the scandal the possibility of severe economic disruption emerges. Fewer than 10 Chaebol control some three-quarters of the country’s production.
Emerging markets otherwise suffer higher debt servicing costs as a result of the rising dollar and rising interest rates.
The table below shows the devaluation of emerging market currencies since November 8 and since mid-2014: