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What have we been up to


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Winds of change sweeping across Europe

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Sometimes stating the obvious reveals the truth that everybody is brushing under the carpet. Globalisation is not paying dividends to the average man in developed countries anymore - and if it does, it does so only to the affluent and financially educated. The process per se has been a welcome phenomenon for as long as the levers of control and reaping of benefits were apparent to the majority. This is no longer the case. 

Real growth in emerging economies, while not giving rise to more democratic governments, has certainly led to the accumulation of wealth outside the developed world. This money is now coming back, moved either in search of stable government or by the desire of the new upper class from foreign countries to diversify its asset holdings. This comes at a time following a long stretch during which the accumulation of wealth in developed world economies became ever more polarised, with the 1% getting richer, and the remaining 99% staying on the same or worsening socio-economic terms. Regardless of the actual pros and cons of this dynamic, real and financial immigration are seen as a threat, and people from well-established democracies are lending their votes to those who listen to their concerns.

Clearly, the voting populations of heavyweight democratic countries are requesting a change of priorities on the political agenda. A quick list of political votes in 2016 shows: the UK vote to leave the EU, the US electing Donald Trump, Austrians giving 47% of their vote in the Presidential election to the far-right party leader, and the Italian Referendum blocking Constitutional reform. These events cannot be considered to form the whole picture unless we also mention the election campaigns and primary votes in France and Germany, showing substantial consensus to far-right parties as they approach 2017 elections.

Fiscal and monetary policymakers, and financial markets in general, have had a lot to do with the dramatic votes cast during 2016. The focus on people’s money rather than their ‘social wealth’ by policymakers has driven a wedge between former leading parties and their voters. European and national institutions have been very slow to see the gap widening, social policies have not addressed the distress, and the length of the austerity period has left many Europeans feeling disenfranchised with the political entity of Europe.

As 2016 hasn’t been a business-friendly year, many will be hoping for 2017 to be a better one. I'm not so sure. First of all, the chances of a number of European countries electing governments who have campaigned on anti-EU tickets are high. France and Italy could easily take this direction, and it is a known fact that a number of Northern European countries are equally dissatisfied with both Europe and the euro. If this happens, volatility on EUR crosses will be inevitable. As a matter of fact, since early November, EUR/USD one-year volatility has moved from 8.75% to 10.75% (around the top of a two year range) and EUR/JPY one-year volatility has moved from 11.25% to 13.05%.

A second key element to consider is the role of the ECB. The bank has been stepping up its monetary easing effort further and further, to facilitate struggling governments and banks. These problems have not been resolved – mainly because while the ECB tried to wash away banking system distress with water cannon, this policy seemed to be thwarted by the metaphorical equivalent of a plastic bag stuck over the drain. In reality, these were the actions of local and national political institutions that used to own and command these banks. In defending themselves, they exacerbated those banks’ balance sheet troubles to the point of collapse. This isn’t only about Banca Monte Paschi, which is on everyone’s mind. It also concerns a whole variety of banks across Europe that the ECB has identified as weak, and has required to beef up their capital ratios.

For those who don’t know MPS as a local bank, one has to consider that it is the only bank in Italy, after Unicredit and Intesa San Paolo, with a unified national network. Its presence in Siena and around Tuscany makes it the bank of choice for the whole of Tuscany. A full default of the bank is still entirely unlikely. If no institutional investors come to the rescue, the bank will be nationalised. The Italian Treasury has already prepared for this Plan B, despite the risk of triggering the controversial bail-in regulation. Equity and subordinated bond holders are facing the risk of having a very large haircut, and deposit account holders will be protected from the default event only up to EUR 100,000. This is an imminent event at this stage, and while the ECB has promised to be ready to address the financial distress that the event could trigger, it is not at all clear how it would manage this.

Finally, interest rates are on the move. The Fed is expected to hike interest rates this afternoon. All of the banks surveyed see the Fed funds rate at 0.75% from tomorrow, and the market is pricing in a 92% probability of a hike, with 100% probability priced in by January. The BoE will stay on hold at least until March, but UK CPI inflation is inching higher at 1.2% and for how long the Bank will continue with the current base rate of 0.25% beyond the triggering of Article 50 is a moot point. The ECB has extended its purchase program until December 2017, but one wonders if this will be sufficient to keep rates very low throughout the year should risks to the stability of the eurozone materialise. Interest rate expectations have all shifted higher from the lows of August 2016 and there is a chance the move could continue in 2017. We suggest that firms should be very careful on the IBOR assumptions used in their business plan calculations, as simply using the present three-month or six-month rates could well lead to disappointment when the market is actually approached.

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



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