Thursday, May 18, 2017

Market Snapshot May 18, 2017

New impulses for the European Union
With the election of Emmanuel Macro as the President of the French Republic, the European project is gaining new impulses. In stark contrast to his challenger, Madame Marine Le Pen who threatened to lead France out of the Euro and even out of the European Union in case she would gain the election, Macron is a staunch European. In his acceptance speech right after the election, Macron demonstrated his full support of a political European Union by having the European hymn being played before the French national anthem. The cabinet he put together includes many members with a pro-European stance.
More turmoil in the United States
Quite different from Europe, where things seem to calm down, the United States moves from one scandal to the next. The presidency of Donald Trump is under fire from all sides. Even members of his own party have turned skeptical about Trump’s capacity to lead the nation. The latest outrage that excited the media all over the United States was the leak that President Trump has shared sensitive national security material with the Russians at a recent meeting in the White House. This comes on top of claims from the opposition party of the Democrats that Trump’s had received support during the election campaign by the Russian government.
Stock market plunges
Partly as a reaction to the political turmoil at the US Presidency, the U.S. stock market has begun to give up some of the gains that the market had won after Trump’s election when rumors were mounting that Congress was trying to initiate am impeachment process against the President. Yet beyond the immediate political concerns, the stock market has also many structural reasons to fall given that valuation are overextended and the real growth prospect much less than the stock market seems to anticipate. Given the important role of the U.S. financial market, a fall of U.S. stocks will also affect the rest of the world irrespective of the specific situation in these regions.
Comeback of the Euro
The widening divergence between the United States and Europe in terms of political stability will most likely lead to a stronger Euro in the coming months. The spread could even get more pronounced when indeed the U.S. president should be confronted with an impeachment procedure. Beyond that, however, there are also fundamental reasons why the Euro should strengthen. France is surely coming out of its long stagnation along with Spain and Portugal and join the strong growth countries like Germany, the Netherlands, and Ireland. This would leave only Italy as a major country that still is in stagnation. Yet should cylinders fire in France, Italy would probably get the required impulses in order to higher economic growth.   
Economic growth
As of now, the improved outlook for economic growth seems to hold. Even is the United States should disappoint in the coming months, economic growth will get stronger in Europe. The result of the French election has given new confidence to European business. Together with the strong growth in Germany, accelerated economic growth in France will most likely spill over to Italy, the third-largest Euro economy. Even more so, there are signs the Japanese economy has finally come around the corner and move out of its decade-long period of low growth.

Prices and interest rates
The fact that price inflation has remained low even in the face of strongly fallen unemployment rates points to the expectation that and the outbreak of inflation is not imminent. There is, however, the possibility that the U.S. central bank could act proactively and go ahead before prices begin to rise significantly. As of now, given the political certainties in the U.S., the chances for a preemptive strike have diminished. Likewise, the European Central Bank will most likely wait at least as the economic situation in Italy becomes clearer. In Japan, the central bank is quite glad that the economy is moving ahead that a decision to raise interest rates is surely not a high priority
The strong labor market performance In the United States, Japan, and Germany will most likely continue.  It remains to be seen how a stronger French economy could reduce the unemployment rate of France, which is still very high. Across Europe, the employment situation is very uneven. This may contribute to a constellation where overall wage demands have remained subdued even in areas with very low unemployment rates. Some of the wage gains have come to the workers through deflation in the form of higher real wages.
Current account and exchange rates
The exchange rate between the U.S. dollar and the euro that has remained very stable over the past years will probably change in favor of a strengthening of the Euro. In terms of the purchasing power, the U.S. dollar is highly valued at its present level. The political uncertainty should come in as an additional factor to correct the overvaluation of the U.S. dollar that has been in place for quite some time and has contributed to a certain degree to the deindustrialization of some parts of the U.S. economy. It remains to be seen, however, whether the exchange rate realignment would be massive enough to correct its impact on U.S. competitiveness and do away with the persistent current account deficits of the United States.
North Korea
Slowly but surely, Venezuela is falling apart. Almost daily, there are deadly protests in the street. The government is helpless and other that to increase suppression has no way out. Foreign help from apparent allied has not shown up. No foreign power from abroad will risk a major geopolitical conflict with the United States by giving full support to the Venezuelan government. As bad as the situation is right now, as fast it could change when the present Socialist government resigns, allows open elections and makes room for a new government that promises to pursue solid free market reforms.
North Korea
Despite all warning, the leader of North Korea, Kim Jon-un, continues to push forward his nuclear program. With strong support from the United States, neither South Korea nor Japan will tolerate this North Korean policy. Yet being aware of the consequence of military conflict, the major efforts concentrate on a peaceful solution. Yet given that even the Chines ally of Kim Jon-un has no control over the North Korean leadership, the conflict is far from a solution and can turn any moment into a dramatic showdown.  
The fears of an economic collapse of China have not materialized. It seems the China has succeeded in settling down on a lower growth project, an adaptation that was highly necessary given the fierce growth of the Chinese economy over the past decades. In as much as the current U.S. administration is stuck in internal turmoil so that China may feel of having a free hand to continue its expansionary moves into the South China Sea. In going ahead with this project, the Chinese leadership may actually have a high interest in reigning in any adventurous movement by North Korea.

Turkey, a country with very close ties to the West – it is a NATO member and has been a candidate for membership in the European Union – is on its way of moving from an authoritarian regime to an outright dictatorship. These links, together with its exposed strategic location in the Middle East make it a pivotal country in the region. Over the past decades, Turkey had made great economic progress. The change towards outright dictatorship means a harsh setback for the economy. It remains to be seen whether from here on Turkey enters the spiral of political unrest and economic decline or whether the country can get out in time from this trap. 
Antony P. Mueller
May 18, 2017

Saturday, May 6, 2017

Market Snapshot May 5, 2017

Is the U.S. stock market ready to pop?

After a sharp fall during the recession in the wake of the financial market crisis of 2008 (see shaded area in the graph below), the U.S. stock market has made a turn-around in 2009. Since then equities have performed a rally that lifted the Standard & Poor’s index of 500 stocks quoted on the New York Stock Exchange from below 800 up to 2399 index points on May 5, 2017. Yet while the stock market’s valuation has tripled over the past couple of years, the U.S. economy in terms of its real gross domestic product has risen by less than 20 percent and in nominal terms about 25 percent in the past seven years.
Standard & Poor’s 500 Index, 2007-2017

Over the long run, stocks correlate with economic growth. There are, however, occasionally stretches of time when stocks outperform or underperform the real economy by considerable margins. Currently, so it seems, stock market valuation are well ahead of the real economy. Empirical evidence shows that market correction take place neither smoothly nor moderately, but the excess to the upside is followed by an excess to the downside and vice versa. 
Are there reasons to believe that a stock market correction is imminent and that such a correction would bring down valuations considerably? Such a question asks for the determinants that have brought about the current high valuations.
One indisputable reason for the elevated valuations of the stocks in the United States is the policy of the so-called “quantitative easing” that made the U.S. central bank (FED) to increase the monetary base from below one trillion to almost four and a half trillion U.S. dollars. Concurrently, the FED has brought down the policy interest rate (Federal Funds Rate) from five percent in 2007 to 0.5 percent in 2009. It was not until towards the end of 2016 that the central bank began to raise the rate in a couple of small steps to the present level of one percent, which is still extremely low.

Interest rates at such a low level have not only led to a frenzy “search for yield”. These low rates have also provoked companies to use their excess liquidity for stock buy-backs. Both policies are about to end and thus a correction of the stock market seems inevitable.
Antony P. Mueller
May 6, 2017