The Weekly - Blowing the bloody doors off!

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04/06/2018
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It has been several months since voters went to the polls in Italy, yet last Monday we were seemingly none the wiser on the long-term political outlook for the third largest economy within the single currency.  The crisis had been on the backburner while the Northern League and the Five Star Movement were trying to cobble together a coalition to govern.  Unfortunately, what they came up with wasn’t palatable to the interim President, Sergio Mattarella, who rejected the coalition’s mandate seemingly on the appointment of Paolo Savona as minister of the economy because he is a hard line Eurosceptic.

 

Markets were understandably jittery last Monday which possibly had huge ramifications, not just for Italy but for the Eurozone as a whole.  In a scene reminiscent of the film, The Italian Job, where Michael Caine exclaims ‘You were only supposed to blow the bloody doors off!’ this crisis still has the potential to blow-up much larger than first feared.  The Greek sovereign debt crisis and even Brexit might pale in significance.  Last Friday did see some progress, however, with both the aforementioned parties submitting a new candidate, which was then approved.  Whilst it is understandable that the EU supported, the president didn’t want to appoint a Eurosceptic as it is difficult to see what they could have done in the long run.  Italians are very passionate people and therefore wouldn’t like to be told that the two largest parties, which they voted for, are not able to form a government.  This move would only have cemented support for both the Northern League and the Five Star Movement if Italy needed to go to the polls again.

The harsh reality for the EU though is the fact that since the introduction of the Euro, the Italian economy has gone absolutely nowhere.

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  GDP per capita (in local currency) Source: The World Bank

 

Since the Euro was introduced, the GDP per capita for Italy has actually declined, whereas the only beneficiary of the single currency, Germany, has greatly benefited.  Understandably Italians want this to change, and both the Five Star Movement and the Northern League believe that the best way to do this is to increase spending.  Italian debt, as a percentage of GDP is already at 139%, second only to Greece which stands at 179%. This makes the UK at 88% seem relatively modest.

Something has to fundamentally change thus allowing the Italian economy and other Mediterranean countries to become more competitive.   While the EU won’t admit it, it is facing an existential crisis, and while the EU is trying to make Europe more inclusive, the rise of the populist parties should tell them that something needs to change.  However, the EU is not known as being receptive to change, and so Italy will increase its spending and debt, therefore increasing the uncertainty that they will be able to pay back their debts.  Bond prices will fall and ultimately interest rates will rise.  We believe that any disaster has been averted for now, but this is not a solution to the problems faced, it is only temporary and like any averted disaster, solutions need to fix the source of the problems or the ramifications can be a lot worse further down the road.

Meanwhile, Donald Trump has decided that he does want a trade war after all, and he has subsequently imposed a tariff on both Steel at 25% and Aluminium at 10%.  This has been imposed on Mexico, Canada and the EU.  Donald Trump is the most decisive figure in world politics at the moment.  He does shoot from the hip and, surprisingly on many of the decisions he has taken so far, it seems to have worked in his favour.  However, should this trade war intensify it will be in nobody’s interest, especially the US.  The retaliations and ramifications against the US outweigh any possible benefit to the US economy.

One possible example that can be illustrated is by using German car manufacturers for instance.  The import tariffs only apply on the raw material of steel and aluminium (so far) and do not include the finished product such as a car.  However, many German cars are actually assembled and made in the USA. According to the Automotive News Data Centre, last year 281,519 German cars were built and assembled in places such as Alabama, Tennessee and South Carolina – rust belt territory.  Two primary raw materials needed for making a car are steel and aluminium.  Without being experts in the automotive industry we don’t know exactly how much of these materials are needed per car or the potential increase in cost, but as a German company would you be prepared to face this increase in cost, or would you simply close down manufacturing plants in the US and assemble the cars in Europe, then export the finished product to the US?

Of course they could buy steel from within the US, but because of the glut outside the US it will still be more expensive than elsewhere.  Furthermore, the horse bolted some time ago, and while there is never a good time to impose tariffs, common sense dictates that you do it when you still have an industry to save.  It would be the equivalent of the UK imposing tariffs to protect steel jobs in Sheffield today.  Donald Trump’s reasoning behind these tariffs is to protect jobs, but then someone pointed out that unemployment is lower than it’s ever been, so it was decided that they would use national security as the excuse, which as everyone knows is complete codswallop.

Instead of living in the past, Donald Trump should learn from the past, specifically the 2002 US steel tariffs imposed by George Bush.  Research has shown that the tariffs adversely affected US GDP and employment. Again, everyone might be underestimating Donald Trump as a dealmaker, and this latest move is simply a ruse to better the terms of any deal for the US.  The looming summit with Kim Jong-Un is one such example; first it’s on, then it’s off, then it’s back on again.  Donald Trump likes to keep everyone guessing, and then make his opposite number feel grateful they are getting any deal at all.

The collective of US allies will call his bluff and we have already seen some retaliatory tariffs announced by the EU.  Being the leader that doesn’t like to lose face, this could leave Donald Trump teetering on the edge, but then again, we suspect that more than once, the Whitehouse may have heard the famous phrase from the aforementioned film - ‘Hang on a minute lads, I’ve got a great idea……..’.  With the November mid-terms looming, it will be interesting to see whether Donald Trump can come up with the goods and save his precious prize.

Equities recover from more geopolitical turbulence

Global equities were little changed by Friday’s close, having recovered far steeper losses sustained early in the week on Italian political uncertainty. The FTSE 100 closed -0.4% lower.

Mainland European markets were unable to recoup the lost ground, the MSCI Europe Ex UK down -1.3% during a politically chaotic week that saw fears of a single currency crisis resurface, the beginnings of a trade war, and the end of long-standing Spanish Prime Minister Mariano Rajoy’s term amid a corruption scandal.  The Euro held firm against both Sterling and the US Dollar, closing the week largely flat.

The US S&P 500 index achieved a +0.5% weekly gain. Friday’s release of the US Labour Report once again underscored the strength in the US labour market.  May’s data showed another drop in the headline unemployment rate to its lowest mark for 18 years, at just 3.8%, while non-farm payrolls the economy added 223,000 new jobs.  Average hourly earnings advanced at a 2.7% rate, year-on-year.  The improved data increased the implied probability in futures markets that the US Federal Reserve will raise interest rates four times this year.  The US economy grew at a 2.2% annualised rate during the first quarter of the year, according to the second estimate from the Bureau of Economic Analysis this week.

The UK manufacturing purchasing managers’ index (PMI) revealed an improvement at headline level during May, with a reading of 54.4, up from the 17-month low recorded in April. The detail of the report suggests there is still plenty of concern for the sector though with new orders, the most forward looking aspect of the data, continuing to fall. Most of the gain came from manufacturers clearing backlogs and a steep build-up in inventories.

Saudi Arabia and Russia hinted last week that easing oil production cuts was an option that they had discussed, potentially adding up to one million barrels per day to offset crumbling Venezuelan output and returning sanctions on Iranian production. The price of Brent crude oil recovered early-week losses to close up +0.5% at just under $77 per barrel.

Week Ahead                                             

This week sees a quieter schedule of economic data releases. The latest PMI data will assess business activity levels in the UK’s construction sector (Today) and its dominant services sector (Tuesday) that accounts for nearly 80% of UK GDP. Services are forecast to see modest growth at a rate broadly unchanged on the previous month.  The US economy will also see its equivalent reading from the Institute for Supply Management (ISM) on Tuesday. US crude oil inventories will also draw attention on Wednesday in the wake of comments from Russia and Saudi Arabia last week about increasing supply.