By Stephen Pope, Managing Partner Spotlight Ideas
We publish, with client approval a series of questions that have been raised on several occasions in the past month. Hopefully our answers will prove helpful and maybe add to the take on the contemporary state of the financial markets and economy. This month we start with here questions about France and the Eurozone/ECB before movingonto look at UK inflation, a Yellen Fed and the long decline in coffee prices.
1. Do you agree with the last downgrade of France´s credit rating by Standard & Poor´s (S&P)?
Yes we do. Since the election of François Hollande in May 2012, plus the election of a Socialist Assembly just one month later the left wing have had complete control of the economy. Several measures that have been unhelpful for business have been implemented.
For example, making it too costly to make workers redundant or to tax profits made by start-up entrepreneurs excessively. This has led to a brain drain of exactly the type of high energy individuals that France needs if it is to compete on the global stage.
France saw its economy contract by 0.1% in Q3 and will be a serious blow to President Hollande. September’s unemployment rate was 11.5% cf. Germany at 6.9% and GDP growth in Q3 of 0.3%.
2. How could this downgrade impact the current policy of French government? Do you think it will reduce even more François Hollande´s popularity and strength other political parties in the country?
Hollande is deeply unpopular…in fact if you look at our recent papers on France you will see that he managed to become the most unpopular President of the Fifth Republic after 100 days in office…worse that Sarkozy and even Chirac. Certainly as the level of unemployment is showing no sign of declining either nationally or among the youth I do see Hollande and the Socialist Party falling further in the opinion polls. In the south they have recently been pushed into third place by the Front Nationale(extreme right) led by Marine Le Pen and the UMP even though the centre right party is in its own state of disarray.
The trouble is Hollande knows he owes a debt to the extreme left within his party and from the Communists who were prepared to back him in the final run-off against Sarkozy. However, the left-wing economic policies do not sit well within the European Union and will only make France even more uncompetitive.
3. Should Hollande and the government take new measures to improve growth prospects and get
the country´s finances in order?
The trouble for France is that Hollande is secure until May 2017…and while the Socialists dominate the political landscape, even though have slipped badly in the polls I cannot see many changes to the left-wing dogma being introduced. For example…just last week the new body to regulate the Eurozone’s banks was created…but already France and Germany are at odds.
The strict rules of the upcoming Asset Quality Review (AQR) and the stress test are that if a bank fails to pass either or both then it has to raise more capital via a share offering to the private sector. It cannot take state aid beforehand. Germany supports this measure but France wants any failing bank to be allowed to seek capital from the European Financial Stability Facility (EFSF). That is a fund put in place for the worst of all cases….but France regards its banks and non-bank financial institutions as national champions.
We would welcome new, pro market, labour reforming laws put in place; that is, however, on our part wishful thinking.
4. Was the ECB correct to cut the refinancing rate last week? Will Draghi go further?
Let us be clear, the ECB has just one star to steer the ship by…price stability, inflation has to be kept below, but close to 2.0%. So when it was reported by Eurostat that consumer price inflation (CPI) in the Eurozone grew at just 0.7% in October, the lowest rate, YoY, in just over four years alarms bells clearly began to ring.
The level of CPI slowed considerably from the previous reading for September at 1.1% and it can be seen that over the past 24 months the latest rate of change in the YoY CPI for the Eurozone is the second largest fall.
Yes, Draghi was correct to authorise a reduction in the refinancing rate last week…but he should have attended to that issue sooner. Similarly, cheaper money does not go far enough in opening up the spigots of lending liquidity. Banks should only lend on a sound commercial basis, but once they have enough capital as a reserve they should be penalised for simply recycling LTRO cash at the ECB. Sooner as against later Draghi has to go for a negative deposit rate …not a just a token level of negativity, rather a progressive penal rate that will make banks think long and hard before simply parking money on an overnight rollover basis with the central bank.
5. What do you think about GDP in the Eurozone…is the region recovering?
The two leading economies of the Eurozone, Germany (#1) and France (#2) released data this morning which showed that their recoveries are stuttering. Germany’s GDP Q3 rose by only 0.3%; France was a disappointment as its economy contracted by 0.1% in Q3.
The overall 17 nation Eurozone expanded by a fragile 0.1% in Q3 significantly down from the level of 0.3% recorded in Q2. The slowdown was expected, however, it is a setback for peripheral economies which had hoped a growth would add jobs. The Eurozone’s unemployment rate is a record 12.2%. The youth unemployment rate in some countries, including Spain Italy and Greece, is two to four times higher. We do not think the region is recovering…it is backsliding and remains as fragile as ever. Markets are far too complacent on this issue.
6. How worried should we be about Italy? If its economy starts to creak the Eurozone could not
afford to bail it out.
Italy is the third largest economy of the Eurozone but is one of least competitive. Italian GDP growth figures
revealed that Italy remains in recession, with a 0.1% contraction in GDP for Q3. That implies a contraction of 1.9% YoY. It always seems to us that it is a last throw of the dice for desperate politicians to point out that the rate of contraction is declining. We accept that the majority of Italian / Eurozone economists propose that Italy’s recession will come to an end in 2014 but any growth will be pitifully slow and inadequate to reduce Italy’s 40% youth unemployment rate. The nation is constantly in the grip of political uncertainty and has an undefined picture of the fiscal composition of the stability law or budget under discussion in the Italian parliament. Italy is to the Eurozone, what Vesuvius is to Naples.
7. What is the interpretation of the low level of UK inflation?
UK inflation dropped, unexpectedly to its lowest rate for more than a year in October. CPI fell to an annual rate of 2.2% in October from 2.7% in September, the Office for National Statistics (ONS) said on Tuesday.
This was helpful in reassuring the Bank of England (BOE) that it has a large degree of flexibility in overseeing a strengthening of the economy before it need to raise interest rates.
The fall was not just driven by one time only effects as an underlying measure of inflation, which strips out increases in energy, food, alcohol and tobacco, rose by just 1.7%. This represented the smallest increase since September 2009. Data also released by the ONS on Tuesday reported that factory gate prices rose by 0.8%, their slowest since October 2009, compared with forecasts of a 1.0% increase on the year. We must be wary of upward pressure on inflation over the next few months, when the impact of recently announced prices rises for household heating take effect.
8. What are your early thoughts on a “Yellen Fed”?
We think the western world should be extremely pleased that we have such a capable individual ready to replace Ben Bernanke in what we sense will be a seamless transition of economic approach. Look at the snippets from the pre-delivery text of her statement.
“…A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on
unconventional policy tools such as asset purchases…Supporting the recovery today is the surest path to returning to a more normal approach to monetary policy. …”
She said that unemployment is
“…still too high, reflecting a labor market and economy performing far short of their potential,…”
On inflation she sees it remaining below the Fed’s 2.0% target objective but is aware that the US economy is an amalgam of different currents e.g. housing “…seems to have turned a corner…” and the auto industry has made an “…impressive comeback …”
Looking over how the street perceives Janet Yellen we expect the Fed will stay on an extremely accommodative course…but not irresponsibly so. She is considered by Wall Street to be a “dove” and as such to be less likely to advocate Federal Reserve interest rate hikes. She has gone on record as being a Keynesian economist (hmm…we have reservations about that) and believes in the modern version of the Phillips curve. (To support that argument will delve deep into theory and research which we do not think Capitol Hill will welcome).
“…The modern version of the Phillips curve model relating movements in inflation to the degree of slack in the economy has solid theoretical and empirical support. …”
In a 1995 meeting of the Federal Open Market Committee (FOMC) while serving on the Board of Governors
of the Federal Reserve System, Yellen stated that occasionally letting inflation rise could be, if it increases output: “… a wise and humane policy…”
9. Coffee has been in a bear trend for over two years…why?
Record global harvests from Brazil to Vietnam are fuelling a global surplus that drove prices down 26% this year, heading for a third annual decline and the longest slump in 20 years.
Global output will exceed consumption for a fourth season in 2014 so making the most enduring supply
excess in 11 years. The sentiment is that the price of Arabica traded in New York will decline 11% to 95 cents a pound by March, the lowest since July 2006. There’s so much coffee available that it will take at least 18 months for supplies to diminish and prices to start rebounding. There are no bullish signals in play.