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Lazard's Flood: The world feels very different than a year ago

18 January 2017

Martin Flood, manager of the Lazard US Equity Concentrated fund, reflects on some of the challenges facing the US and global economies during the first quarter.

By Martin Flood,

Lazard Asset Management

The world feels very different than it did a year ago. A new administration is preparing to take office in the United States. The United Kingdom’s government is preparing to negotiate its exit from the European Union. Italian voters rejected constitutional reforms by a 20 percentage point margin, leading to the resignation of prime minister Matteo Renzi.

However, as we reflect on 2016 and look forward to 2017, it is worth noting that on many levels our fundamental view of the US and world economies has not changed meaningfully. Instead the logic behind our expectations has changed. In the quarter ahead we expect to see the following highlights:

Trump’s first 100 days

While president-elect Trump’s cabinet has largely taken shape, there is still very little detail on the new administration’s policies and priorities. There is also a lot of uncertainty over how well the Trump administration will work with Congress and the bureaucracy to move forward on its priorities, given the number of outsiders involved.

Finally, there are questions about how much opposition the president-elect will face, given the divisive nature of the election and his willingness to flout precedent and tradition in communications with world leaders and the public. Trump’s early days in office should provide important insight on all of these issues.

US inflation from 2006 to November 2016

 

Source: Bureau of Labor Statistics

Inflation

In the past we have highlighted how rising wages, fading base effects of low oil prices, and the potential for an acceleration in health care prices could contribute to a gradual rise in inflation. This gradual, underlying trend can be seen in smoothed measures of US inflation, which began slowly moving back toward the Fed’s 2 per cent target well before the election.

Adding to the upward pricing pressure for goods, global producer prices have been increasing, most notably in China where the year-on-year change in the Producer Price Index (PPI) turned positive in September after being negative for 54 consecutive months.


While the recent appreciation of the US dollar could temper some of this growing inflation pressure by dampening import prices, we expect inflation to continue to grind higher. US trade policy changes could substantially increase inflation rates going forward.

President-elect Trump campaigned on a protectionist platform, which could include tariffs on goods imported into the United States, and the house Republican tax reform proposal includes a border adjustment tax that could raise the cost of imports. Assuming no change in trade and border tax policies, we expect inflation to increase on the margin in 2017. If meaningful policy changes are enacted that penalise imports, we will have to revisit this view.

Monetary policy divergence

On 8 December, the European Central Bank (ECB) extended its asset purchase program through 2017 and made other changes to ensure that it could continue to buy large volumes of bonds while maintaining its negative interest rate policy (NIRP).

Specifically, the ECB broadened the maturity range for its purchases of government bonds, allowed purchases of bonds with yields below its deposit rate, and announced that it will reduce its asset purchases from €80bn per month to €60bn per month from April 2017. On 20 December, the Bank of Japan (BoJ) maintained its NIRP and its asset purchase program.

The ECB and BoJ’s divergence with US monetary policy mirrors the situation at the end of 2015. As we pointed out at the time, monetary policy divergence limited the FOMC’s ability to hike rates, as a global financial feedback loop tightened financial conditions in the United States much more than a 25 bps hike had done in the past. This mechanism now is apparent in the appreciation of the US dollar and the move in US rates since the election. We believe it likely will force the FOMC to move more gradually than many expect.

Chinese growth and the renminbi

The Chinese economy surprised on the upside in 2016, as the government boosted spending meaningfully and as credit flowed freely, supporting growth. However, easy credit inflated fears of a housing bubble across the largest cities leading to new measures to clamp down on borrowing and speculation.


As the year wound down, the Chinese renminbi depreciated further, increasing pressure on the capital account as Chinese companies and residents tried to move capital out of the country. Looking forward, we expect growth to decelerate further in 2017 and the renminbi to continue weakening modestly against the US dollar, despite ongoing intervention by the Chinese authorities.

An appreciating US dollar and rising US rates could place additional pressure on the renminbi, and highlight one of the many policy dilemmas facing the Chinese leadership, namely keeping financial conditions tight enough to discourage asset bubbles and capital outflows while also meeting its 6.5 per cent annual growth target. Pressure to strike the right balance is even more acute ahead of the 19th National Congress of the Communist Party of China in the autumn of 2017, an important political milestone.

EU politics

The unexpected results of the Brexit referendum and the US presidential election, and the unexpectedly wide margin of defeat in the Italian constitutional referendum, have highlighted the politics of economic insecurity and national identity. In the eurozone, where the currency union’s uncomfortable marriage with national interests has been at least partially responsible for a slow recovery, political risks are likely to continue to rattle markets.

UK prime minister Theresa May has indicated that she will invoke Article 50 in the first quarter of 2017 to start formal negotiations for the United Kingdom’s departure from the EU. These negotiations will provide a backdrop for national elections in most of the euro zone’s largest economies, where eurosceptic parties have gained popularity in recent years. The current expected political calendar includes the Dutch general election in March, French presidential election in April and May, French legislative election in June, German general election later in the year, and a chance that Italy will return to the polls.

In our view, the French election is the most worrisome as there is a meaningful chance that the National Front, a nationalist political party, could win the election on an anti-euro, anti-EU, anti-immigration platform. Irrespective of who wins these elections, it is also important to note that a number of governments in Europe are operating without a clear mandate—for example, Spain. The challenge of weak governments is that they might not have the authority or majority vote required to make tough decisions in a crisis, increasing the risk of political fragmentation.

Martin Flood is manager of the Lazard US Equity Concentrated fund. The views expressed above are his own and should not be taken as investment advice.

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