The Ally Pally Analyst

Poland and Hungary love poking the EU bear.  It plays well domestically and corresponded with easy economic and fiscal times.  There has been almost zero downside to their strategy. 

What Viktor Orban in Hungary and the Law and Justice (PiS) party in Poland don’t realize, is that eventually, the bear always bites.  While they try to sell the conflict as between Brussels and the countries, it is actually between them and the voters. Brussels is a convenient target to distract from the damage these administrations are doing to their countries.  In Poland and Hungary, it might just be the voters and not the EU, that bite first.

This anti-EU movement was one aspect of the platform that brought PiS to its unprecedented victory in 2015 and has kept them in power since. PiS won by drawing on the general disenchantment with the liberal elite and the specific feeling of missing out on economic opportunity felt by the population outside of Warsaw. 

Several other factors contributed to their victory. The opposition was disjointed as its former leader and perfect poster child for European-centric elites, Donald Tusk, was busy as then-current president of the European Council. Good economic times also contributed to the victory. 

While anti-EU rhetoric was part of a path to power in Poland, it became a mechanism for retaining power in Hungary.  It served Orban well to distract from his and his party, Fidesz’s, raid on institutional strength and rule of law.  Orban, now the country’s longest-serving prime minister, has been on quite the ideological journey.  Bringing Fidesz along for the ride, Orban made the move from center-right, classical liberal, and pro-European to right-wing national conservatism and some would say, kleptocracy.  This change led to Fidesz’s temporary expulsion from the European Peoples’ Party as well as its eventual permanent exit after the introduction of Rule of Law language in the EPP’s bylaws. 

Between 2010 to 2020, Hungary dropped 69 places in the Press Freedom Index and 11 places in the Democracy Index; Freedom House no longer categorizes the country as ‘free.’

Since 2015, Poland has dropped 44 places in the Press Freedom Index. From 2015 to 2020, Poland recorded the biggest decline of any country in the World Justice Project’s Rule-of-Law Index and dropped six places in the Economist Intelligence Unit’s Democracy Index (where it is now classified as a “flawed democracy”).

The EU has hit back at the countries, but not about its barbs.  It openly criticized the deterioration in rule of law, human rights, and media freedom in the countries and stated it was in direct opposition to the EU’s shared values and baseline rules for membership.  It triggered Article 7 proceedings in December 2017 for Poland and September 2018 for Hungary. 

Before the EU could begin Article 7 deliberations, it paused them in light of COVID and the global pandemic.    In the meantime, both countries have continued their attacks on rule of law culminating in the latest court decision in Poland that the Polish constitution has primacy over EU law, challenging the bedrock of the EU’s foundation. 

There is no interesting economic backdrop to these governments’ current political path.  The economies have benefited immensely from being part of the EU and there is no desire to leave the EU.  Currently, the countries are recovering from the pandemic and trying to face down inflation.  This is a unique situation in that the power grab needs an enemy and Brussels, and its overarching liberal philosophies are it.

At this point, it is unlikely the EU will be quiet or passive.  It no longer has German Chancellor Angela Merkel reigning in any conflict between the eastern countries and Brussels.  Patience is wearing thin.  It is difficult to see the EU disbursing €36bn in pandemic recovery funds to Poland and the €7bn to Hungary while the question of adherence to EU law and human rights, corruption, etc remains unanswered. Poland is also due to receive €121bn and Hungary €38bn in EU development aid by 2027. Surely EU taxpayers will be up in arms about those disbursements and Polish and Hungarian voters will be as well. 

Will Polish and Hungarian voters bite their administrations before Brussels gets the chance?

Hungary’s next election is in 2022 and a large part of the opposition has joined together, across the spectrum, to try to beat Orban and Fidesz.  On Sunday 17 October Conservative politician Péter Márki-Zay won the primary to be the opposition’s candidate for prime minister.  He won’t have an easy job as recent pollings put the two groups on even ground.  However, the debate is being framed as ‘Orban or Europe’ and that polling is more decisive.

In your opinion, what would be the consequences if Hungary left the European Union?

Poland is due for its next election in 2023.  The polls there suggest no domestic pressure on PiS from Tusk’s opposition. Will this change when there is a risk to roughly 30% of GDP worth of aid from the EU over the next 6 years?

The EU is a different animal today.  Its passivity shouldn’t be taken for granted.  Firstly, with Merkel gone, there is a different level of cooperation and power-sharing than before.  Second, the EU seems emboldened to act after years of talking and it has significant financial levers available.  Thirdly, the upcoming election in France is likely to add to anti-Brussels rhetoric. The EU won’t be able to actively push back against French politicians but it can show its strength via asserting its authority in Poland and Hungary.  

The EU was able to make the UK’s exit fairly painful by following the rules.  It is likely it will apply that same process to Hungary and Poland. It will do so with a very large amount of money behind its threats. 

Will voters in Hungary beat the EU to the punch?  If Hungary can shake loose of Orban’s authoritarian grasp, Poland loses its ally and likely its bravado.  If Orban remains, then the EU will act.  It is only a question of time and which bear, but the bite will come.

Feel free to file under Poland and Hungary:  EVENTUALLY YOU GET BITTEN

Originally published 14 October 2021

Boris Johnson is using Brexit to distract voters from what matters. Still. The UK has a bad case of Long-Brexit, and it will slowly eat away at the country’s pandemic recovery potential. 

There is so much going on in the UK right now beyond Brexit.  Some of it is the government’s fault, some of it not.  Regardless, the government’s job is to smooth economic cycles, protect the most vulnerable, and provide public goods. 

The Johnson administration is failing at all three and setting the country up for short- and medium-term pain. 

Let me caveat all my great proclamations with this:  we are very much still in the pandemic and very much still in a complete supply and demand dislocation.  These challenges are global in nature and unprecedented.  Developed markets have done well with providing liquidity during the height of the pandemic.  Now they must move from crisis management to planning for the recovery.  This entails trimming of excessive liquidity and long-term planning. 

Alas, I dream of long-term planning governments, and then I wake to reality.

The UK government is not making any long-term plans.  Instead, it is sticking with the same plan since 2016.  Brexit, Brexit, Brexit.   

Boris knows his original backers are mostly unaffected by the dislocations due to the pandemic.  They continue to be mostly in an economically insulated bubble.  The anti-EU rhetoric and inflammatory soundbites on Brexit keeps them on Boris’s side. 

In a wonderful confluence of interests, ‘winning’ on Brexit also keeps the marginal Boris supporters happy.

It seems to distract them from 1) the end of furlough 2) mismatch of skills to labour market 3) looming higher energy costs 4) looming tax increases 5) looming rate hikes and 6) a trade war with the EU, their largest trading partner. 

When anyone brings up 1-6, Boris reverts to Brexit. Does it reassure the country that as long as the European Court of Justice or Brussels isn’t telling them what to do, it doesn’t matter if they can afford heat or buy food for Christmas? 

Boris is sticking to his Long-Brexit mantra regardless.  It doesn’t seem to be helping him keep afloat in the polls. But with no election on the horizon and no functional opposition, why not take the easy road of continuing to beat the Brexit dead horse versus actually working at his job?

Boris shares more in common than just hair colour and number of wives and chidren with the former American president, he shares the canny ability to dodge political damage despite being significantly incompetent.  As much as it will pain them to even consider the thought, Labour needs to look to the US and see how Democrats were able to challenge Trump at the poll box if not on soundbites. Then there may be hope for the UK when there is an election. 

In the meantime, Gilt 10 YR yields are rising.  Expectations that the Bank of England will raise rates are now firm with a heated debate about just how soon that will happen.  February 2022 at the latest and possibly an early November surprise.  

The imminent hike is on the back of a surge in inflations in August.  Consumer Prices Index plus housing costs (CPIH) reached 3.0% in the 12 months to August 2021, up from 2.1% in the 12 months to July.  This 0.9% increase is the largest on record, but it is largely attributable to base effect.

3% is high and compared to August 2020 at 0.5% it looks horrific. 

However, remember last summer when we were all eating out in the UK but only paying for half of what we ordered as the government picked up the rest of the tab?  That pushed down inflation significantly and now that we are forced to pay for our own food, shocking as it may be, inflation is surging.  But the BoE isn’t buying the transitory inflation story. 

Sterling is strengthening against the dollar and the euro as well.  Neither gilts are sterling look attractive if, unlike the government, you can manage a little forward-thinking. 

Today actual GDP data doesn’t look bad in comparison.  August 2021 say a 0.4% growth in GDP over July.  July was revised down to -0.1% from 0.1% growth.  This is still 0.8% below its pre-coronavirus (COVID-19) pandemic level (February 2020).  This is roughly better growth than seen in the US or Europe currently.  However, expectations are for growth to slow from here on.

The full force of the gas price increase is unlikely before April 2022 given how the regulatory system works in the UK.  April 2022 is when the new National Insurance tax hike is scheduled to come into effect.  Will the Winter of Discontent actually turn into the Spring of Discontent? 

Employment data has also continued to improve but with the Furlough scheme still on the books it is hard to see through the noise.  We’ll start to have a clearer picture with October data after the formal end to the Furlough scheme on 30 September. 

The labour shortage is also something batted off by Boris.  His suggestion is that there is just a period of adjustment and that we shouldn’t resort to immigration is challenged in both the near term and the medium term.

A recent study by the Institute for Fiscal Studies suggests the surge in vacancies has been driven by low-paying occupations, where new job openings had risen about 20 percent above pre-pandemic levels by June 2021.  But that almost 8 mln people, a quarter of the workforce, in higher-paid service jobs would struggle to find employment. 

This does not suggest that the UK post-Brexit is gearing up for growth and expansion anywhere but in the low-paying sector.  That doesn’t sound like a winning combination for recovery. 

The UK is being bogged down by Long-Brexit. Unlike long-covid, there is a cure:  a functioning government not distracted by the endless project that is Brexit.  And it will benefit many more than the empty promise of freedom from the tyranny of the European Court of Justice.   

Feel free to fill under: POLITICIAN, HEAL THYSELF, OF LONG-BREXIT     

Originally published on 9 August, 2021 for Ohmresearch.

It is hard to break the cycle of not worrying about Germany. But you should.  

Almost 16 years of Chancellor Angela Merkel and a clear path of negative rates from the European Central Bank (ECB) can make a person complacent. 

Add that to the European Union’s 2021-2027 budget including its “Next GenEU program” and the Recovery and Resilience Fund (RRF) and it is even harder to break out of that complacency.

Unfortunately, we need to turn a more critical eye on the country and its political choices. In September’s Bundestag election, German voters are making decisions that will truly affect everyone. 

It is hard to imagine what could happen that would shock German Bunds out of negative yielding territory.  Even the German 30 YR is headed back negative after a brief sojourn into positive yields.  The election result in September is unlikely to do it. It doesn’t mean you shouldn’t worry.

German Yield Curve

No ECB decision is likely to rocket yields higher in the short term either.  At its 22 July meeting, the ECB said it would keep buying bonds to support a Eurozone recovery.  New language about tolerating moderate inflation and a transitory overshoot may have upset Jens Weidmann but honestly, what has the ECB done in the last 15 years that hasn’t upset this uber hawk. 

Global inflation numbers are giving the whole world a bit of a wobble.  Inflation in the 19 countries sharing the euro accelerated to 2.2% in July from 1.9% a month ago.  In Germany, July inflation beat expectations of 2.9% coming in at 3.1%. This is expected to continue to tick up as the economy reopens and new measurements of the basket of goods feed through. 

YoY June 2021 Inflation

However, the ECB continues to view this spike as transitory.  The same story is putting pressure on central banks and markets in the US as well but it will take a bold and confident central bank to raise rates now. 

The big caveat here is I’m talking about developed markets.  Emerging Markets are already hiking.  We’ll talk about that shortly. 

But the EU is haunted by its reversal of accommodative policy too early during the global financial crisis and the sovereign debt crisis.  Even if you think the pendulum has gone too far towards easing, there is no appetite outside of Weidmann, and possibly the Dutch, to tighten either fiscal or monetary policy.  The EU’s 7-year budget and the RRF will keep fiscal expansion in place.  It doesn’t mean you shouldn’t worry.

I thought that the Greens’ strong momentum earlier in the year held so much promise both for Germany and the EU.  Now the chances of meaningful change to the European status quo are diminishing alongside the Greens’ polling.

Voting Intention for the September 2021 Bundestag election

The US’s blessing of Germany’s deal with Russia over Nord Stream 2 only entrenches that status quo further.  Nord Stream 2 and Merkel’s international lobbying for it leaves no space for the next German administration to move away from fossil fuels or Russian energy sources. 

The US was rightly concerned that an unchecked Russia with an even greater ability to manipulate energy supplies to Europe might pose a danger to Ukraine, Europe, and themselves. 

However, the US found a way to deem Merkel’s pledge to act on any undue pressure from Russia as sufficient. This is despite the fact the pledge is so vague that it wouldn’t even keep my 4-year-old in line. 

Now that Merkel knows she is headed out of government, is she’s eyeing what other chancellors have done in the private sector?  It would make for an easy transition since she’s already lobbied for the organization with other governments. Though it would break the hear of many a Merkel fan. However, I took her photo off my mantel a couple years ago.

Merkel provided such strong and steady leadership in Europe throughout the global financial crisis and the sovereign debt crisis.  Her actions anchored the EU. 

However, the truth is that Germany was the leader for crises but not for change.  Merkel was able to control the panic but not craft a long-term solution or put Germany or Europe on a path for the next generation. 

The Greens seemed perfectly poised to take over from crisis to planning, or truth be told, from economic crisis to climate crisis. 

But alas, the Greens stumbled too.  Unfortunately, none of the candidates across the parties are connecting with the voters.  There is a real risk of a weak chancellor.  Without leadership in Germany, the EU will likely fail to move from crisis management and fighting about EU harmonization .  And leadership in Germany looks in short supply.  This is when you should worry.

Feel free to file under:  AAA-RATED COUNTRIES CAN AND SHOULD KEEP YOU UP AT NIGHT.

The violence in Colombia is a result of several health, social and economic pressures erupting at once. 

They are not unique to Colombia and can easily be imagined in other countries in the region and emerging markets in general. The health, social and economic crises are all leaning heavily on fiscal stability that is making investors and rating agencies nervous.  

The International Monetary Fund (IMF) has given its blessing to grow fiscal deficits. Is that only for developed markets though because emerging market investors don’t seem convinced it will be ok on the other side of the pandemic? 

Colombia’s fiscal problems, like many emerging market countries, aren’t just a product of COVID but they were definitely magnified by the pandemic. Assessing whether the government can turn the ship post-COVID is how emerging markets investors will make money. If the governments try to front-run expectations of fiscal tightening, possibly to avoid a rating downgrade and curry investors’ favour, it will likely be detrimental for the medium-term outlook as they own viability.  

It is premature to speak of a post-COVID recovery and premature for governments to think of reigning in spending in emerging markets. COVID is still very real amongst its populations and the health crisis and the resulting economic crisis is still very real despite developed markets out at the pubs and planning holidays.  

The IMF continues to tell countries not to worry about deficits, however, investors and rating agencies are already worried about what fiscal stability looks like for emerging market countries on the other side of Covid. That is what good analysts do. Though it misses the actual circumstances on the ground.  

Maybe zoom due diligence trips aren’t efficient after all.

What we are seeing now is Colombians reacting to what they perceive as swift kick while they are already down. There wasn’t much confidence in the Duque administration from day 1 but after 18 months and a health and economic pandemic, faith in the administration is zero.

Colombia needs fiscal reform. The country has a narrow tax base and could do more to promote investment. There are many aspects of the failed reform that make sense. Those aspects were lost to headlines alerting many to their new tax liabilities and an increase and expansion of VAT to basic items. The administration’s inability to talk through the reforms and try to win any understanding compounds the fears that this entitled and isolated administration cares nothing for the continuous suffering on the streets.

Then we have the reality of a violent response to protests. Colombia is a country globally associated with violence but has made phenomenal strides towards rule of law and peacefulness. Not only the peace accord with armed militias but on the street as well. Murders per capita have plummeted from the highs of 84.2 per 100,000 in 1991 to 24.3 per 100,000 in 2020. What is going the other way is the brutality. The number of massacres, defined as more than 3 murders simultaneously, has grown. There were 90 massacres in 2020 up from 36 massacres in 2019, 29 in 2018, and 11 in 2017. 

Colombians have suffered brutal violence this past week. Both police and protestors have been killed and injured. This is a population at the end of its tether and being asked to face continued uncertainty about any return to normal or any return to growth from a completely out-of-touch administration.

It doesn’t take a lot of creativity to see the same situation playing out elsewhere in Latin America or elsewhere in the emerging market world.   

It is a very tricky time to assess sovereign creditworthiness. The growing balance sheets globally are encouraged and needed. Make no mistake though: there will be a very different lens applied to emerging markets than developed markets. Investors and rating agencies appear to ignore the US and others’ expenditures, except in the context of possible inflation. However, emerging market downgrades are mounting.  

Source:  CountryRisk.io

There aren’t a lot of administrations or institutions in emerging markets that inspire blind confidence but if one were to, it might be Colombia. It lives in a neighbourhood of chronic defaults and doesn’t. It has repeatedly made the right fiscal choices but now it is facing falling below an investment-grade rating and incurring the forced selling and higher borrowing rates. It can’t all be blamed on COVID but there is a lot that can.

The country will avoid a downgrade because the new finance minister, José Manuel Restrepo will do enough to soothe all interested parties. And the global attention regarding the violence and rejection of austerity during a still very real pandemic will be enough to make the rating agencies hold steady.

There has already been a bounce in Colombian assets after the resignation of Alberto Carrasquilla and the appointment of Restrepo, a non-political figure already using the right language and enough fiscal levers to ease tensions.  

Source: Tradingeconomics

The question of how to gauge an emerging market country’s ability to tolerate the health, social and economic crisis’s toll on its balance sheet will remain. This time last year, the IMF and the whole emerging market ecosystem were calling for building back better. It is hard to identify any spending that contributes to the future when all resources are dedicated to surviving today.  

There has never been a harder time to price risk. The global pandemic, IMF’s support for deficit growth, the Debt Service Suspension Initiative, and high global liquidity all combine to cloud fundamental analysis. 

But investors still have to invest. Where to go then? I’ll take a crack at sorting that answer in the next missive.  My response will weigh heavily on whether administrations across emerging markets learn anything from Colombia’s attempt to tighten the purse strings too early.

Feel free to file under:  THE FAT LADY HAS NOT STARTED SINGING YET

The United Kingdom’s future is not just a question of how it develops outside the European Union but if it survives in its current form. Boris Johnson and and his England-centric administration are being tested by increasing demands for independence from Scotland, Northern Ireland, and even a pro-Brexit Wales. Will he rise to the occasion?

There isn’t much time left for Johnson to sing a bit of Rule, Britannia! and get the other countries in line before Scotland votes on 6 May for a new parliament or violence becomes entrenched again on the island of Ireland.  

I’m going to go out on a limb and say that even if he had a lot of time, that little diddy might not hit the right note.  

While we wait to figure out the UK’s new global role outside of the EU, will we find out the old UK is gone forever? Instead of a new independent UK will will be trying to slot not only a significantly diminished UK but an independent Scotland and a unified Ireland into the world as well?

The UK left the EU to assert its sovereignty and regain some fictional past of all mighty glory and abundance. However, it may be the nail in the coffin of the 314-year union. Scotland and Northern Ireland remind everyone then can that they did not vote for Brexit and that Westminster increasingly does not serve its interests. Even the pro-Brexit Wales is finding the Johnson administration’s England-centric policy and behaviour trying.   

As the UK tries to assert itself again as an independent global leader, the Johnson administration needs to recognize the value in the unity of the four nations. The inability of Johnson to make policy for the whole country begs the question of how the UK will fare in its recovery plan and what growth looks like going forward.  

The UK isn’t unique in its big-spending to counteract the pandemic. Its economic contraction and expectations for growth aren’t out of line either. It is unique that it will face the Brexit fallout at the same time, but the Johnson administration isn’t trying to separate the two ills anytime soon. 

Economic realities don’t weaken the desire for independence; it seems to strength the desire to plot one’s own course. Scotland and the UK in general were in a better place when the first independence referendum went to the Scottish people in 2014. Today, an independent Scotland would only have harder choices to make to come to a respectable deficit level but that isn’t damping the emotion. 

Just like many a referendum, it is more personal politics than economic motivation in these questions. We won’t have to wait long for an answer. Scottish and Welsh elections will be held in less than a month. Polling suggests the possibility of a rare Scottish National Party (SNP) majority in Scotland or at least a pro-independence majority.  

Elections in Scotland and Wales are unique in their structure; they meant to avoid easy majorities by design. There are ‘constituency’ representatives, elected using the first past the post voting system and ‘additional’ representatives elected based on the proportion of votes a party secures in a region comprising several constituencies. This structure and the possibility of an SNP majority speaks to the strength of the Scottish independence movement at this time.

On top of elections in Scotland and Wales, a wave of violence has erupted in Northern Ireland as it marks the century of the creation of Northern Ireland. 

There are many competing inputs and a mix of history, current circumstances, and just time of the year that contribute to the current spat of violence. There is so much more history about the island of Ireland, the creation of Northern Ireland, the Troubles, and the Good Friday Agreement than I can explore here but please see some links at the bottom of this document. It is such a more nuanced history than what I learned through Hollywood or the American school system (unfortunately sometimes one in the same) but one that has shown its propensity for violence and shouldn’t be dismissed by Westminster.   

Today the unexpected strict interpretation of the Northern Ireland Protocol by the EU, the unprepared UK, the emotional turmoil created by the border in the Irish Sea, and the quickly approaching the 100 yr anniversary of the creation of Northern Ireland have conspired to bring forth a much more balanced debate and support for a reunified Ireland.  And violence.

These separate events across the UK challenge the England-centric Johnson but he’s only offered pithy remarks and brighter Union Jack flags in reply. His one-liners from the Brexit campaign on the greatness of the UK ring a bit hollow now.

Johnson does and doesn’t have time on his side. The Scottish, Welsh, and island of Ireland politicians are already fighting for their self-determination and it will be hard to put their ambitions back in the bottle.

However, the pandemic has created the acceptance of deficits to support the recovery so there is an arsenal of resources to paper over the cracks with short-term spending.

The question remains is Johnson going to continue with his restrictive view of the UK, ie London, or try to woo the hinterlands into cooperation? I’m betting that he remains short-sighted in both his actual vision and his ambition for the UK or whatever we call it when it is only England and Wales.  We’ll have to temper our outlook for the UK as well.  Thank goodness it looks good compared to the EU.   

• 

Feel free to file under:  WHAT WILL THEY SING AT PROMS?

https://www.newyorker.com/magazine/2015/03/16/where-the-bodies-are-buried

https://www.bbc.co.uk/newsround/14118775

The European Union relies too heavily on German Chancellor Angela Merkel. For the first time in 16 years, she’s not an option. Now the EU will have to learn to survive without her or a strong Germany. Is this a bad thing?  

European leadership in both national capitals and Brussels will have to figure out how to advance the EU values and economic recovery without Merkel, for better or worse. It is hard to think of the EU collective leadership rising to the challenge given they have never done it before. This is likely to leave the EU in a continuous internal political battle with only fits and starts at making the Union ‘ever closer.’

Or will a change in typical German domination of the EU political space create the room for European leadership to find a more uniform and balanced voice? One that can resonate globally as well as domestically and not just in response to Germany? I find that unlikely but not impossible.

There was a glimmer of hope with the July 2020 agreement on the €750 billion recovery effort, Next Generation EU, to help the EU tackle the crisis caused by the pandemic. This announcement made it look like the EU could come together in this crisis, work together and think strategically about the future.  

However, that quickly changed as the pandemic continued. The EU’s long-term budget negotiations were bogged down with issues from a variety of countries, each one playing their stereotyped roles and again raising the question of whether the EU could ever actually work together.  

In the meantime, Joe Biden’s and the Democrats’ victory in the US righted the almost capsized American ship. 

Boris Johnson’s popularity recovered after sinking on the back of delivering 1) a less immediately traumatic Brexit and 2) vaccines. The EU fell back to third place.  

Now, not only does the current environment look marred with a resurgence of COVID-19 but we’ve started the countdown to the September election in Germany. The first in 16 years without Merkel. Everyone is starting to realize that it is highly likely that Germany isn’t going to have the capacity to drive the EU as it did before.

Right before I began my homeschooling adventure, I wrote about how Merkel needed to exit the scene to prepare Germany and Europe for the post-Merkel period. It would be hard for any leader, let alone a popular one with 15 years in power under her belt, to leave during a crisis. However Merkel should have made space for an heir. History is littered with leaders who stayed too long.

Merkel’s party, the CDU/CSU, has been in power for too long and is too associated with the status quo. They themselves can’t make a decision on how to best proceed. What made Merkel great was her ability to read public sentiment and tack to the middle ground, making everyone happy and avoiding controversy. It seems that the German public is tired of the middle ground and playing it safe. They are looking for a new direction. The Greens ascendancy in polling demonstrates that.  

The CDU/CSU division on who to put forward as a candidate should have been resolved internally and long ago. However it hasn’t. Armin Laschet, leader of the CDU and from North Rhine-Westphalia continues to jostle against Markus Soeder, the leader of CDU’s Christian Social Union sister party in Bavaria. Laschet is closer to a continuity candidate while Soeder has been more outspoken and definitive in his views which is proving more popular currently. Neither is likely to change any policies significantly. The question will be is if CDU/CSU can maintain its small lead to be the governing party in the coalition.

Where there may be an opportunity for renewal and a different path forward comes from the strength of the Greens and the possibility of a Green Chancellor. The Greens have long been ticking up in popularity, sitting comfortably in 2nd place, and could change Germany’s political trajectory. 

There are two major questions regarding the Greens: 1) which of the co-leaders, Annalena Baerbock or Robert Habeck, will ascend to the candidacy and 2) how much will the Greens change in power?

The Greens have a unique opportunity. The climate is front and centre to many voters, the Greens look increasingly moderate and pragmatic, and Merkel’s and the CDU/CSU position is weakening. The Greens in Germany are likely to be better partners to national leaders throughout Europe given they won’t have Merkle’s singular force. This weakening of power could be better for the EU. It could help support a more collaborative and collegial EU versus one responding to a forceful Merkel.

What it won’t do is anything interesting to German Bunds. It does however begin to develop a sightline to better and sustainable growth in Europe. It also starts to create a foundation for a changing Europe that not only talks about sustainability but implements it. Depending on the specific country’s plans for use of the Next Generation EU funds, it also makes you think there is a possibility for change in Italy.  And peripheral bonds start to get a lot more interesting. 

And if that is a step too far along that sightline, we still have a very accommodative ECB to smooth the path in the short term. But we can’t take that for granted for too much longer.  The US is starting to wake up to that idea already.

Feel free to file under:  IT CAN’T ALL BE MERKEL OR MONETARY POLICY FOREVER

My guiding light during times of crisis has always been a little scene from the 1988 film Colors with Sean Penn, Robert Duvall and directed by Dennis Hopper. None of the language is appropriate but the gist is you have to be patient. Patience is a key requirement for looking at Emerging Markets and basically everything else. It helps you think straight when markets move like they have with Coronavirus or you are on your second marriage.

Patience is part of the three amigos of creative thinking and assigning probabilities. If an analyst can manage to keep all three of those in check while a portfolio manager yells at them, the screens are red and fundamental analysis doesn’t seem to matter, then there is hope to survive a market rout.

Right now, everyone is trying to be a virologist and savvy about calling a bottom. I’m going to take a lesson from my long, illustrious 5-day career of home-schooling to declare stick with what you know. What I know is sovereign debt analysis. I’ll try to apply that thought process to Brazil and Turkey and see what we get. Remember, patience is good for me and you!

By the way, Brazil and Turkey make a nice little pair. Leaders of both countries are under the assumption that they themselves elevate the credit quality of their countries and they are both wrong. Look at the currency, the credit ratings as well as the declining popularity. Jair Bolsonaro and Recep Tayyip Erdogan believe their own hype and their own cult of personality. They are both bringing unnecessary pressure on their economies without the growth and prosperity they’ve promised their populace.  

Bolsonaro wears proudly the moniker of ‘Trump of the Tropics.’ Trump has squandered the US’s moral high ground and its global leadership. Trump has stripped the US government of the brain capacity to do much except for trying to keep the stock market at or above a certain level. Which lots of people might say doesn’t matter in the grand scheme of things. I think it does; ask Venezuela about the importance of institutions and smart bureaucracy to keep de facto dictators in check and economic Armageddon at bay.  

The US retains its global standings but only as a shadow of what it was before. Brazil doesn’t have that far to fall nor currency reserve status to buoy it. Luckily Bolsonaro isn’t quite as destructive as Trump. Brazilian institutions are looking increasingly resilient; Congress is strengthening from its previous position as a rule-taker. States are independently taking action when Brasilia fails to act. The Lava Jato experience strengthened faith in the judicial system. The passage of the pension reform suggests that weights on the fiscal side may ease going forward. Brazil could survive Bolsonaro yet. Though this little global pandemic complicates the future.  

On the flip side, Erdogan has weakened the majority of Turkish institutions in his quest to consolidate and extend his reign.  There are movements afoot to wrest control from him. Long-time Erdogan ally and founding member of the AKP, Ali Babacan announced the formation of a new party in March 2020. Deva, or ‘remedy’ in Turkish, is set to challenge the AKP and what Babacan has labeled as the destruction of Turkish institutions.  Only a few months earlier, former prime minister, Ahmet Davutoglu left the AKP and established the Future Party to rival the AKP.   The rerun of the March 2019 mayoral election in Istanbul that resulted in the June win of Ekrem Imamoglu as well as the original victory in Ankara mayoral election for the CHP candidate also signals that Erdogan and the AKP are losing their grip.

Coronavirus and the threat of severe economic depression have thrown Erdogan’s usual tools of anti-Kurdish rhetoric and military action, continual tussles with Russia over Syria and manipulation of the refugee situation with the EU out the window. Erdogan is looking increasingly weak. Elections aren’t scheduled until 2023 but the view that Erdogan may not last that long is gaining traction.    

For the investor, Brazil and Turkey are big emerging market markets. Brazil accounts for 3.27% of the JPM EMBI Global and Turkey, 5.73% making them the 8th and 5th largest components, respectively. Within this USD index, Brazil has returned 4.13 YTD and Turkey -1.42 YTD. JPM’s GBI-EM index, which is made up of local currency bonds, has Brazil unhedged performance at -9.03 YTD and Turkey -6.21.  

Dollar strength during this crisis isn’t a newsflash. It is expected as a flight to safety, plus EM countries have cut rates like it is going out of style. Both the Real and the Lira have been beat up pre-Coronavirus as well but hard to say they are cheap now. Domestic factors might suggest a buying opportunity but this is a USD story and not a Real or Lira one.

Low growth and negative views on Brazil and Turkey are lost to the wider Coronavirus market meltdown. Unfortunately now is the time to examine what developed markets can do as that will be a stronger influence on currency and economic outlook. Everyone quickly switches from a virologist to a Fed analyst.

Developed market central banks and governments are coming out swinging which is positive but there is still too much unknown to hazard a guess on if it will be a short and deep or long and deep crisis/recession/depression at this point. Brazilian and Turkish authorities have also cut rates and announced some measures but the message isn’t consistent and the response is limited. While the countries have larger fiscal space than historically:  Brazil recorded a multi-year low in 2019 at 7.1% of GDP and while Turkey sailed past its 1.8% of GDP target to 2.9% of GDP, mainly due to election spending, it is still smaller than previous years. Historically, the quality of the spend is low and the effects limited and short term. Poor execution doesn’t give confidence that announced fiscal programs will have the power to change the growth trajectory of these countries.

There is no reason that either of these countries will uniquely buck any downward global trend. While Turkey will benefit and Brazil suffer from low oil prices, that will not be enough to override a decline in global consumption and trade with developed markets.

There are a lot of vulnerable EM countries; Brazil and Turkey are only two of the biggest ones that might have been working on borrowed time.  There are a significant amount of countries looking at real fiscal pressure with unsustainable debt maturity profiles. The IMF is standing at the ready but we might start to think about if IMF assistance will be the same or look different. Different and less benign to investors.

Brazil and Turkey will not decouple from EM as a whole but they are definitely higher quality with better prospects than the majority of recent entrants into the EM space.  There is a realistic path that can be plotted towards a turn-around in these two countries. Bolsonaro won’t be in power forever and there is renewed faith in Brazilian institutions. Coronavirus may accelerate Erdogan’s exit with some capable alternatives for leadership already on the horizon. Compared with other EM countries that gluttonously issued debt over the past 18 months, Brazil and Turkey, look like stable EM countries with only temporary challenges brought on by its current leadership.

In the meantime, it will be a painful process to sit through the market volatility and the specific market pressure that will come to bear on these countries as well as global population in the face of this pandemic. Almost as painful as switching to fulltime parenting. But like I tell the kids, you’ve got to be patient. Do your homework and be patient. But do it in the other room!

Feel free to file under TIME TO WATCH 1980s MOVIES

The Catholics have made a lot of mistakes but one-pope rule shows why Angela Merkel should have left the public eye a while ago. Merkel was the sun to Germany’s and the EU’s world through a difficult period but this Merkelcentric period is over and she needs to leave.

Merkel’s desire to preserve her legacy will only destroy it and complicate German politics in a time when the local and global economy isn’t robust enough to handle yet one more political upheaval. If she doesn’t take the long arm approach during this leadership challenge, Germany will suffer as well as Europe and her reign will be viewed as quaint and antiquated as the geocentric period.

Too bad the storyline isn’t new. 

The successful politician always stays too long, the dollar-peg is always held too long, the interest rate is kept too low too long is also proving to be a bit accurate. Unfortunately, all decisions are ultimately made by humans and the tendency is always to stay too long at the party. There is a lot of evidence that Annegret Kramp-Karrenbauer was not the right politician to run the CDU or be Merkel’s heir apparent, but it was clouded by Merkel’s heavy hand. Her 52% victory over Friedrich Merz’s 48% in December 2018 wasn’t overwhelming and her mini-Merkel rhetoric suggested nothing but continuity without dare-I-say The Merkel Charm.  

Now the economy is even worse and where action is needed we have a political vacuum. The economic outlook looks set to worsen until there’s more transparency and hopefully resolution around the Coronavirus but that doesn’t seem to be on the horizon. I thought I’d escape mentioned Brexit but this is also the time that EU unity and direction needs to be laser-focused and it won’t be and that is on Merkel.

German industrial production in December slumped 3.5% and European Industrial production contracted 2.1% and this is all before the Coronavirus or COVID-19 as we are supposed to call it (ask the artist formerly known as Prince how renaming goes). Recent IMF data also shows that Germany is exporting a larger portion of its GDP to China than even the US. The weakening Euro adds concern but still doesn’t trigger buying or a buoy to growth.

AKK is out as the next chancellor but will stay on as leader until there is a single individual selected to run both the CDU and as its candidate for chancellor. The field is already largely decided: Armin Laschet, who runs North Rhine-Westphalia, Germany’s largest state, and is a staunch Merkel supporter and holds her view of the CDU as a big tent party and would welcome coalitions with the Greens; Merz, a pro-business former CDU parliamentary leader and ex-Blackrock Germany chairman with a slant to the right and a critical view of Merkel; and Jens Spahn, the young health minister and it is actually hard to write much more about him.

Spahn is young, energetic and ambitious. While 2020 might not be his year, he’s got a lot more time than the rest of the field. Spahn was also first out of the previous leadership contest and as noted above, Merz lost to AKK by 35 votes in the final round in December 2018.

But to focus on just the CDU for Germany’s future is to miss a big part of the picture. Merkel sticking around has cost the CDU dearly despite how the next leadership/chancellor candidate round goes. The economy isn’t doing her any favors either. Too bad she didn’t move faster on the Schwarze Null and the risk of recession might not still hang over the country’s head. But she isn’t the first one that didn’t listen to me. But the CDU isn’t the only game in town: the Greens are on the ascendancy and are looking stronger and stronger at a time when mainstream politicians are losing their standing globally.  

The Greens are making sense on spending to upgrade transport, digital, energy and other infrastructure, listening to me on the Schwarze Null and a higher minimum wage, rent caps and removing recently implemented changes to the welfare system to make it more generous again. Polling is still 2nd place but the economy is looking worse as are the other political parties.  

The CDU leadership contest was accelerated by its partnering with the AfD in an obscure operational vote in Thuringia but concerns about AfD’s ascendency are well-founded given the global lurch to populists and nativists. The Greens offer a better way to cast off the oppression of historic party rule. Their leadership would be the change everyone wants without the need to swallow the bitter pill that many other countries are choosing when tossing out their status quo leaders.

Feel Free to File Under: NOT QUITE WHAT WE NEED TODAY BUT COULD PAY DIVIDENDS IN THE SHORT TERM

Before you decide to read this on your personal device, don’t worry, it is about sovereign debt. Developed Market debt is boring. Boring is never sexy, or at least that’s what we thought when we were young. 

There was an interlude when Developed Market sovereign debt was the most interesting game in town.   Greece, Iceland, and Eksportfinans brought the mostly dismissed asset class into the spotlight. But now we are back to the boring:  predictable government policies and transparent, or mostly transparent, balance sheets.

Except with negative rates and declining net issuance as well. Just to add insult to injury, there is just enough economic growth to keep the EU from bickering amongst themselves and push down any potential political risk. It could drive an analyst to distraction. 

Emerging Markets are sexy. Emerging Markets is where it takes a detective working both the quant and the qualitative side of things to hack out the investment thesis. Or it did at one point. Now there’s enough liquidity sloshing around that this type of sexy is a bit end-of-the-night, too-much-to-drink faux sexy.  

It is a hard job if your mandate restricts you to high-quality sovereign debt and you are expected to make a return. There’s the folk who use to make a decent, though low return, and that fit their risk profile just fine.  Then there’s those who have no choice.  Regulatory capital requirements force a fair bit of buying. 

In addition, the whole view of hold-to-maturity is changing. High-quality sovereign bonds bought for their safety and interest payment are now viewed as a price appreciation play and capital gains opportunity.

I am the first one to put my hand up and say that I did and continue to think you buy Italy on any weakness.  In this environment, I think that’s the wisest choice in a sovereign only universe.

There is no change on the horizon that will change the current situation. Unfortunately, the Euro area is growing just enough to keep it out of emergency measures but not enough to count out additional expansionary policies from the ECB. The 1.2% outlook for GDP growth in 2020 and much the same in 2021 doesn’t support any change in the ECB’s dovish stance. Inflation expectations, as measured by the world’s favourite indicator, shows an increase but still a long way until near, but below, 2%.

Oh, and the net supply of euro-area sovereign debt continues to tick down, with German bunds leading the way. The likely fiscal expansion program in Germany is still not likely to be sufficient to move the needle on net issuance.

In the meantime, its spread compression everywhere as far as the eye can see. Close that eye in special cases like Venezuela, Lebanon, and Argentina. But those stories are truly idiosyncratic.   Oh and EM issuance is expected to decrease for 2020 as well.

I remember very vividly in early 2007, a senior EM sell-side guy telling me a little pearl of wisdom. Sometimes you have to decide to get on the train or run over by the train. It is not a nice position to be buying things you don’t like at the current valuation. It is very much not sexy. But cash is even less sexy.  

Feel Free to File Under DEPRESSING THOUGHTS ABOUT THE MARKET