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Eurozone defies expectations

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Markets have a habit of wrong-footing their participants and one of their favourite methods is the sharp reversal of a trend that had become so entrenched in traders’ minds that it had become ‘received wisdom’ or the ‘consensus view’. 

Two examples are currently playing out. The first is the entrenched belief that the Eurozone is doomed, as a result of its single currency and ‘one-size-fits-all’ monetary policy, to sclerotic levels of growth compared with the US – and even the UK. However, the Eurozone economy has been sharply outperforming the US for months now, to the extent that markets are looking for signs from Mario Draghi at this week’s Jackson Hole symposium that he is about to start reining in the ECB’s asset-purchase programme. The euro has already been a beneficiary of this, as the realisation that things are suddenly changing for the better in the Eurozone has led to the covering of the hedge fund community’s aggregate short EUR/USD position, which had become a very overcrowded trade.

With EUR/USD, at 1.1740, off its recent highs but still firmly supported, the euro has also been strengthening against sterling. GBP/EUR trades at 1.0960 at the time of writing and this time, it really does look like parity is within striking distance. Years ago, we might have assumed that a weaker pound would benefit the UK by making life easier for exporters and reducing imports, thus providing a further boost for domestic producers. 

Having witnessed the sharp sterling depreciations in 2008 and 2016, however, it is clear that the ability of the UK economy to rebalance itself away from consumption and towards investment via currency depreciation has been significantly overstated by many. Indeed, exports seem little affected by a weaker pound (probably on account of their tendency to be high value and price insensitive), while consumers continue to buy imported goods – particularly food – as prices rise. Hence the depreciations of 2008 and 2016 did little for UK exports but did lead to (mercifully temporary) blips in inflation.

The second consensus currently surprising market participants is that Japan, on account of its aging population and ferocious competition from other Far Eastern manufacturing nations, is doomed to deflation and low growth for years to come, despite PM Shinzo Abe’s best efforts at kick-starting the economy with his ‘three arrows’ of monetary easing, fiscal stimulus, and structural reforms. 

Announced in 2012, the three arrows seemed to miss their target for many years. Then, suddenly, last week it was announced that Japanese GDP in the second quarter to June this year expanded at an annualised rate of 4%, against expectations of 2.5%. Six months ago, there were very few forecasters suggesting that both the Eurozone and Japan would be outperforming the US half way through the year. 

In the UK, despite the much-better-than-expected inflation numbers a fortnight ago, the earnings data released last week confirmed that real average earnings growth remains negative. Despite this, retail sales in the year to July managed to post an unexpectedly high annualised real increase of 1.5%, showing that the UK consumer continues to prove extremely resilient. A potential worry, however, is the level of credit. Only a month ago, Alex Brazier, the Bank of England Director for Financial Stability warned of the risk to the economy of the growing ‘spiral of complacency’ amongst lenders from banks to car-loan providers. Certainly, one need not go very far virtually anywhere in the country before seeing, in the form of brand new, gleaming, automotive metal, the signs of champagne lifestyles being lived on beer budgets.

On the subject of budgets, it is interesting that Britain’s divorce bill for Brexit appears to have fallen from the first-mooted €100 billion to a much more manageable €40 billion, though Downing Street has denied its willingness to pay this amount (which means it is almost certainly true). Spread over a number of years, this amount may be manageable but whether it is reasonable is a different matter. The encouraging thing, though, is that the number has already dropped by €60 billion which means that, when it comes to Brexit negotiations, whether or not David Davis is making it up as he goes along, Michel Barnier most certainly is.

Market reaction to last Friday’s departure of President Trump’s Chief of Strategy, Steve Bannon, has been very muted. Some commentators have suggested that staff departures and the earlier disbanding of Trump’s two business advisory councils and failure to initiate an Infrastructure Council will reduce the likelihood of any meaningful stimulus package. However, markets gave up on Trump’s promises of a vast infrastructure programme months ago. Indeed, it is a sad sign of this presidency that the FX and bond markets shake off Trump’s White House shenanigans with such ease. It is as if nothing surprises anymore. 

This week is not a big one for data. In the UK, public-sector borrowing figures are released tomorrow but these are largely ignored by the markets nowadays. Of more significance will be the Eurozone PMI data on Wednesday. These are expected to show manufacturing and services recording 56.3 and 55.4 respectively, in a continuation of the better news emanating from the Continent. European consumer confidence is also improving. The net confidence balance will also be released on Wednesday and is expected to show a level of -1.8 for August – slightly down on July’s -1.7. This may not sound terribly bullish but this indicator was last in positive territory as long ago as 2001 and bottomed out at -34.6 in March 2009. Anything close to zero is therefore very encouraging and a move above zero, which looks likely this autumn, is set to further thwart euro bears.

All views expressed here are the .author’s own and are based on information and data available at the time of writing

 

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