Yesterday, senior EU negotiators warned that “the chances of Britain crashing out of the EU without a new (trade) deal were now “over 50%””. Clearly, therefore, the UK’s preparations are not going well.
Instead of building trust, the UK’s Brexit Secretary, David Davis, seems to think that threats – such as promising “the row of the summer” – are the best way to open discussions.
I have taken part in major trade and contract negotiations around the world. Based on this experience, I believe his strategy is very unlikely to succeed. It risks instead leading to a populist-style “Battle with Brussels”, which the UK will lose. The UK will then crash out of the EU – with no deal on trade – long before the March 2019 deadline.
PREMIER MAY IS IGNORING HER OWN WARNING LAST YEAR
My key concern is that premier Theresa May seems to be ignoring her own warning before last June’s referendum:
“The EU is a single market of more than 500m people, representing an economy of almost £11tn ($14bn) and a quarter of the world’s GDP. 44% of our goods and services exports go to the EU, compared to 5% to India and China. We have a trade surplus in services with the rest of the EU of £17bn. And the trading relationship is more inter-related than even these figures suggest. Our exporters rely on inputs from EU companies more than firms from anywhere else: 9% of the ‘value added’ of UK exports comes from inputs from within the EU, compared to 2.7% from the United States and 1.3% from China….“(my emphasis)
I am not alone in my fears. UK industry is becoming very worried about what may happen. Paul Drechsler, President of the Confederation of British Industry (CBI), spelt out the key issue last week – the need to maintain access to the Single Market and Customs Union. He described the journey of a computer chip made today in Cardiff’s tech hub:
“The chip is bought by a company in Germany. The metals inside it are sourced from South Africa and Turkey, using free trade agreements the UK has through its EU membership. Some of the plastics inside it are processed in Poland and Spain. Engineers from France, Croatia and Hungary worked alongside Brits in Cardiff to design it. When finished, it is packaged by a worker from Bangor, Wales and delivered to the port by a driver from Slovakia.
“The chip has been made to European standards, its design protected by a Europewide trademark. It was insured with a financial package covered by EU passporting and, when incorporated into a machine and put in the shop, it will meet Europewide levels of consumer protection.
“In other words, for that chip, and the British company that makes it, to remain as competitive as today we need: three new trade deals, free movement of EU citizens, three new sets of internationally approved regulatory and copyright standards and an agreement on EU financial services passporting.”(my emphasis)
A hard Brexit, without access to the Single Market or Customs Union, will not just impact the UK. As the CBI example confirms, today’s complex and extended supply chains mean that companies across the EU27, and around the world, will find their trade disrupted.
RULES AND REGULATIONS ARE AS IMPORTANT AS TARIFF BARRIERS TO MOST COMPANIES
Many in the UK chemicals industry – the UK’s largest manufacturing export earner – are also very worried. Its largest customer, the car industry, is totally dependent on global supply chains and just-in-time delivery, as the chart shows. Going back to a pre-Single Market world of tariffs, customs barriers, endless form-filling and border delays will lead to major uncertainty and loss of business.
And, of course, tariff barriers – although important – are not the only issue. The future role of the European Court of Justice, and the rules and regulations under which products are sold, are even more critical, as a new survey by the British Coatings Federation confirms:
“Over three quarters of our members said that a separate UK chemical regulatory system would be bad for business. Maintaining regulatory equivalence with key EU regulations (REACH, CLP and BPR) through continued relations with institutions such as the European Chemicals Agency is essential to ensure we have a strong UK manufacturing base that can import chemical raw materials from Europe, and export finished goods such as paints, coatings printing inks and wallpaper without being at a competitive disadvantage.”
BREXIT RISKS ARE BEING IGNORED IN THE UK ELECTION CAMPAIGN
Given the criticality of these issues for the economy, they should be the major topic of the current election campaign. But instead May’s election manifesto simply promises:
“As we leave the European Union, we will no longer be members of the single market or customs union but we will seek a deep and special partnership including a comprehensive free trade and customs agreement.”
She seems to expect the Brexit negotiations to follow the pattern of the Treaty of Lisbon in 2014:
Then the UK appeared to “opt out” of key domestic and legal policies to pacify the Eurosceptic tabloid media
Behind the scenes, however, it negotiated a special Protocol 36
After signing the Treaty, the UK immediately “opted back in” to many of the policies via Protocol 36
But it is very hard to see how this can happen with Brexit, as EU Commission President Juncker warned last month.
I am therefore not optimistic about the outcome of the talks. I correctly warned – over a year ago – that Brexit was likely. Having followed developments since then, I find it hard to believe the EU 27 will allow May a back-door re-entry via a new Protocol 36-type deal, after a “hard Brexit”. This seems a totally unrealistic objective.
I hope I am wrong. But if I am right, the current UK government strategy means there is no “business as usual” option for the vast majority of UK companies – or for many EU 27 and non-European businesses. I fear, as I have warned since March 2016, “Brexit will hit UK, Eurozone and global economies“.
Europe is heading in to the Great Unknown, as Monday’s post highlighted. The UK, The Netherlands and France are not the only political uncertainties that we face. Elections are also due in Italy and in Germany.
Italian elections. After premier Renzi’s referendum defeat last year, it seems like that Italy will hold elections this year, probably in the next few months. A the moment, the most likely winner is former comedian Beppe Grillo. As I have discussed before, his main policy is for a referendum to exit the euro, but stay in the EU. But, of course, it is also possible that the current Gentiloni government might survive until the scheduled election date in 2018.
If Grillo wins, the entire European banking system is likely to go bankrupt, as well as the European Central Bank (ECB). The reason is that leaving the euro, and returning to the lira, would inevitably lead to a major devaluation of at least 20%. As the ECB is the main owner of Italian government debt, thanks to its Quantitative Easing programme, it also would go bankrupt. As Astellon Capital note, the critical legal issue is that the Bank of Italy is privately owned by the Italian banks – not state owned. The ECB claims the government would still be responsible for the debt, but investors and other governments are unlikely to wait around for Italy’s slow-moving courts to reach a decision.
German elections. In October we then have the German elections, where Angela Merkel is seeking a fourth term. Her credibility has been badly damaged by her handling of the refugee crisis, although most polls suggest she is still the favourite. Germany also has a growing challenge from an anti-EU party, the Alternative für Deutschland (AfD). But her main opponent is the new pro-EU leader of the Social Democratic Party (SDP), Martin Schulz.
A win for Merkel would obviously be “business as usual”. But if Schulz wins, he would bring a new dimension to the political debates over the future of the EU, as he was the President of the European Parliament until he resigned to seek the leadership of the SDP. Whereas Merkel saw herself as a “safe pair of hands”, Schulz is likely to be a more activist Chancellor, if elected. His reputation at the Parliament was of “someone who got things done”. But his actual policy objectives are unclear at the moment.
COMPANIES AND INVESTORS NEED TO PREPARE FOR VERY DIFFERENT OUTCOMES
Voters have got tired of waiting for change to take place. As I noted in November, 69% of Germans, 82% of Italians and 89% of French feel their country is going in the wrong direction. So they are prepared to try different options, just to see what might happen. In turn, this means that Europe, and the world, is entering a Great Unknown. At least 4 quite different alternatives could therefore result from this year’s elections:
Business as Usual. Perhaps Rutte, Fillon and Merkel will win their elections, Gentiloni survive into 2018, and May get her Brexit deal. But this seems just a 10% probability today
A triumph for the Populists. Populist success could continue, with Wilders winning in The Netherlands, Le Pen in France and Grillo in Italy, whilst the AfD wins a strong position in Germany. This is a 25% probability
Smörgåsbord. Each country might go its own way, with Wilders winning in The Netherlands, Macron winnng in France, Gentiloni surviving into 2018 in Italy, and Merkel winning in Germany. This is also a 25% probability today
A New Broom. Wilders wins in The Netherlands and Grillo in Italy, whilst Macron and Schulz win in France and Germany. This is perhaps the most likely outcome, but has only a 40% probability
Each of these outcomes would have radically different implications for companies, investors and us as individuals. The Populist, Smörgåsbord and New Broom outcomes would also give very different outcomes for the Brexit process. It could easily become of only marginal importance for EU leaders, if “business as usual” options disappear. In turn, this would make May’s position back in the UK, very difficult indeed.
Nor can one ignore the potential impact of events, such as a Greek default, or of further interventions by Presidents Trump and Putin. Both would be happy to see the EU disappear. These widely differing alternatives highlight the dangers of continuing with a one-dimensional view of the world based on economics. Political risk has returned, and is likely to continue rising up the agenda for a long time.
We are entering the Great Unknown in Europe over the next 9 months. Everyone will have their own views of the probabilities. But the crucial point is that every country in the world is likely to feel the impact, in some way, if “business as usual” fails to occur. And it will then be too late, at the end of the year, to suddenly wake up to the implications for your business, and for you personally.
Next month sees the start of a process that could change all our lives. Whether we live in Europe, or outside it, the political decisions about to be made have the potential to impact every country in the world – for better or worse.
And yet, nobody has yet begun to put together the various pieces of the jigsaw, and identify the wide range of different outcomes that could emerge. By the end of the year, the EU and the eurozone might have collapsed – with massive impact around the world. Or ‘business as usual’ might continue. Or we might have a revived French-German partnership again, reigniting the energy that first began to rebuild Europe after World War 2. None of us know, and it is very dangerous to keep pretending that ‘business as usual’ is the only option.
The changes are so vast, and so different in their potential outcomes, that I will explore them in two separate posts this week. Today, I will look at Brexit and the current outlook for the Dutch and French elections. On Thursday, I will look at the outlook in Italy and Germany, and draw some conclusions about what may happen.
Brexit is the first unknown. The UK expects to start the process of leaving the European Union (EU) next month. Premier Theresa May has now published the government’s position on the talks. But what will happen when she presents her terms in Brussels? She wants to retain access to the Single Market for critical UK industries such as financial services, autos, aerospace and chemicals – but she doesn’t want to allow immigration to continue on the current basis, and she probably doesn’t want to pay the €60bn bill that Brussels believes she will owe on leaving.
So what will happen? Will it be sweetness and light, with everyone singing “For she’s a jolly good fellow” as she walks out the door? Or will there be furious arguments, and no agreements for UK trade in the post-Brexit world? And what will happen back in the UK while all this takes place? Will businesses simply sit back? Or will some decide it would be prudent to move to France, Germany, Ireland or elsewhere? And what might happen in Parliament, where May only has a majority of 12, if things go badly? Could her term as premier end up being one of the shortest on record?
The Dutch elections are the next unknown on 15 March. Geert Wilders, the anti-immigration, anti-EU candidate for premier, is currently leading in the polls. But will he do better, or worse, when the time comes to actually vote? As we know from the Brexit and US Presidential elections, the polls are not always accurate – if people who have not voted in the past, now decide it is time they went to the polling station. And if Wilders does win, will he be able to form a government? Current premier, Mark Rutte, has said he will refuse to work with him. So it could be a very lengthy process before The Netherlands has a new and stable government.
And what would happen if Wilders did become premier? His main policy is leaving the EU. On what terms would he seek to do this – would he adopt the same positions as Theresa May, or would he have different priorities? And would the EU itself survive the departure of one of its original 6 members? Many people think it wouldn’t.
France’s presidential elections are next, on 23 April. French polls were completely wrong in the primaries – Alain Juppé was defeated by Francois Fillon for the Republican nomination, Manuel Valls was defeated by Benoît Hamon for the Socialist nomination. At the moment, Emmanuel Macron with his new En Marche! movement, and Marine Le Pen of the National Front, seem likely to go through to the final round. Their outsider status is critical to their appeal, but their policies couldn’t be more different. Macron wants to revive the EU, le Pen wants to leave it.
What would happen if Le Pen wins? Almost certainly, the EU would collapse – whether or not Wilders had already begun the process. And what would that mean for the European and global economies? What would happen to the value of the euro? What would happen to the euro itself? Would all the break-up decisions be taken rationally, or would they happen late at night, after bitter argument?
What about the alternative, a win for Macron – who only declared his candidacy in November, and is still forming his new party? He has recognised that the curo cannot survive in its current structure, and has argued the EU should develop “a roadmap for Europe” in critical areas including defence, security and the economy. If fellow social democrat, Martin Schulz, were to be elected Chancellor in Germany in October, the stage could be set for a dramatic reshaping of EU policy – and probably also its membership. The contrast with Ms le Pen’s plans couldn’t be stronger.
GREAT UNKNOWNS LIE AHEAD OF US
These uncertainties would be difficult enough to manage on their own. Brexit itself is a complete unknown, effectively tearing up the last 43 years of UK law and economic policy. But it could easily be over-shadowed by developments in The Netherlands and France. If either or both decide to leave the EU, who really knows what would happen to the European and global economy, the value of European currencies, or Europe’s relationships with the rest of the world?
But these uncertainties are only part of the Great Unknowns now ahead of us.
On Thursday, I will look at the highly uncertain political outlook in Italy and Germany. I will also highlight the very different possible outcomes from Europe’s plunge into the Great Unknown – which has the potential to impact all of us, whether we live in Europe or elsewhere.
2016 saw the Great Reckoning for the failure of stimulus policies begin to impact companies and markets.
The blog’s readership has increased significantly as a a result, as shown in the chart above, with its visits now totaling nearly 500k. Its readership includes 197 countries and over 11k cities. Readers also remain very loyal, with one in two reading it every week, and one in four reading it every day.
The key issue is that consensus wisdom has clearly failed – once again – to provide a reliable guide to the outlook. By contrast, the blog was one of the first to explore the attractions of Populist policies, and to suggest that the UK government would lose the Brexit vote, and that Donald Trump would likely become President.
Even today, however, most “expert commentary” continues to ignore these developments, and the later Italian referendum, and instead believes we will see “business as usual” in 2017. Yet developments in the world’s 2 most important economies, the USA and China, suggest that in reality, this is the least likely option:
In the USA, President-elect Trump continues to focus on the need to reshore jobs from overseas, particularly China, in order to “make America great again”. As Peter Navarro, head of Trump’s new White House National Trade Council, told the New York Times:
“Imposing steep tariffs on China was an essential step to begin to address the American trade deficit with China, which reached $365bn last year. He blamed Chinese trade practices for “destroying entire industries, hollowing out entire communities” and “putting millions out of work.” His colleague, Prof Greg Auty added:
“The Trump camp was dead serious about its threats to impose tariffs on China. The goal is to force manufacturers to come back to the United States as a condition of selling into the American market. A full-on trade war between the world’s two largest economies would cost American jobs in the immediate term, but eventually millions of new ones would be created as the United States again hummed with factory work.
“We moved our supply chain to Asia in about two decades,” he said. “You certainly can do it in the U.S. a whole lot faster. It’s going to take a few years, but it’s going to be a much better America.” (my emphasis)
In China, as Xinhua reports, bursting the property bubble has become the key target of government policy:
“President Xi Jinping highlighted curbing property bubbles at a meeting of the Central Leading Group on Finance and Economic Affairs on Wednesday, the fourth time asset bubbles were mentioned by Chinese leaders in the second half of the year.
“China will take a varied approach to regulating the property market, adopting financial, fiscal, tax, land and regulation measures to build a long-term housing mechanism that provides housing for all people, according to Xi. Thanks to policies introduced by local authorities in October, the property market in big cities continued to stabilize in the last month, gradually retreating from sky-high prices.
“Houses are built for living, not for speculation,” policymakers have agreed.”
In addition, of course, a number of major challenges exist in other parts of the global economy:
The recent Italian referendum means the collapse of the Eurozone has become a real possibility
The future of the European Union itself is also under threat given the Brexit votes and upcoming elections in The Netherlands, France and Germany
Oil markets will likely see further volatility as the inevitable cracks appear in the recent OPEC output cuts deal
India’s currency reforms pose a further threat to the outlook for the world’s 6th largest economy, as premier Modi’s 50-day deadline for resolving all the problems ends today
I will do my best to follow these and other critical developments in 2017. Thank you for your continued support.
Italy was one of the 6 founding members of the European Union (EU) in 1957, along with France, the Netherlands, W Germany, Belgium and Luxembourg. Its referendum next month will therefore be a critical test of whether the Eurozone and EU can survive the pressure from the Populists.
If the Populists win, then the future of the Eurozone and the EU itself will be in doubt.
As often happens at critical moments, the subject of the referendum is of relatively minor importance. It was called by Premier Matteo Renzi to amend the constitution by approving a reform of Italy’s Parliament. The problem is that he then made himself the key issue in the referendum, by promising to resign if he lost, as he confirmed to Italian media last week:
“If the citizens vote no and want a decrepit system that does not work, I will not be the one to deal with other parties for a caretaker government”
Italy is now in a 2 week blackout period for polling before the vote on 4 December. But the final polls showed the “No vote” with a comfortable lead. There is therefore a major risk that Renzi will soon be following UK premier Cameron out of office. 3 quite different Scenarios could then develop:
Another premier takes over. Italian premiers have historically not lasted long. Before Renzi took over in 2014, there had been over 50 different premierships since Italy’s first post-War premier, Alcide de Gasperi, resigned in 1954. So maybe, the revolving door revolves again, and a new premier is appointed by the President
New elections are held, and another premier takes over. Renzi was the 3rd Italian premier in a row to take office without have a personal mandate from an election (neither Mario Monti or Enrico Lette had this). An election may therefore take place, after which perhaps the revolving door revolves again
New elections are held and an anti-euro coalition takes office. This would seem to be the base case Scenario, with a probability of at least 50%. It would likely means that Beppe Grillo’s anti-euro 5 Star Movement would take office with Berlusconi’s Forza Italia and the Northern League, and would then hold a referendum on leaving the euro – with the aim of capping Italian debts and nationalising its banks, as Grillo has promised
Given that around €360bn ($400bn) of all Italian loans are classed as “troubled”, and amount to around one-fifth of total loans, capping the debts would cause major disruption to the Eurozone and global financial systems. Leaving the euro would also mean, that foreign holders of Italian debt would be paid in Italian lira, not euros. And presumably this would be after a devaluation of the lira. So as the Financial Times warned on Monday:
“Since banks do not have to hold capital against their holdings of government bonds, the losses would force many continental banks into immediate bankruptcy. Germany would then realise a massive current account surplus also has its downsides. There is a lot of German wealth waiting to be defaulted on.”
DEMOGRAPHIC REALITY IS NOW CONFRONTING STIMULUS FANTASY
Italy’s real problem is not its Parliament, but that its economic policies haven’t adjusted to the New Normal world. Like most developed countries, politicians of all parties have failed since the end of the BabyBoomer-led SuperCycle, to understand the trade-off that has taken place between increased life expectancy and economic growth. Italy has a median age of 45 years, and as the chart above shows:
It now has only 24m in the Wealth Creating 25 – 54 cohort, versus 22m New Olders in the 55+ cohort
By 2030, it will have just 20m Wealth Creators and 26m New Olders
This is completely different from the 1950 position, when there were 18m Wealth Creators and only 8m New Olders
In addition, of course, Italy has become the main route for migrants and refugees following the EU’s deal with Turkey. 168k people have already arrived this year, compared to 154k in the whole of 2015 and 170k in 2014. Resources have been further strained by the sequence of earthquakes, which are made worse by the lack of anti-seismic regulations for its buildings.
It is small wonder, therefore, that the 5 Star Movement is building support, having won Rome in this year’s elections, whilst the Lega Nord (Northern League) won the Veneto and Lombardy regions.
Nor is it surprising that investors are starting to panic. As I discussed on Monday, Italy’s 10 year interest rate has doubled to 2% since the summer. It could go very much higher if Renzi loses, as the prospect of a vote to leave the eurozone and cap Italy’s debts comes closer.
This is the Great Reckoning in action, and there is probably little that the European Central Bank (ECB) can do to mitigate the position. In a few weeks’ time, investors may well wonder how they allowed Italian interest rates to trade below US rates for much of the past few years. And in a few months’ time, it may well seem equally incredible that anyone ever believed ECB’s President Mario Draghi’s 2012 boast that:
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.
It could be a very difficult H1 in 2017. Next month’s Italian referendum is followed in March by Dutch elections and in May by France’s Presidential election. Both may well be won by parties committed to leaving the EU itself.
It is therefore hard to ignore the possibility that by June, the EU could have effectively ceased to exist in its current form. Developing a contingency plan, in case this develops, could well be the wisest move you make in 2016.
We are approaching the 2nd anniversary of the Great Unwinding of policymaker stimulus, which began in August 2014:
- The initial movement was very sharp, with Brent falling 53% by January and the US$ rising 23% by March
- Oil then saw an initial correction – with Brent recovering to being 37% down by May during the “oil rig rally“
- After that, Brent again fell away sharply to be 72% down by January this year
- Since then we have seen another correction, with the “price freeze rally” taking it to 52% down last month
- Meanwhile, the US$ has been stable, trading in the +14% – +23% range set between March – May 2015
The oil price movements highlight how markets will often not move in straight lines:
- Some traders will decide to take their profits and sell after a sharp move
- This will encourage others to think there is a chance to jump in and profit from at least a temporary bottom or top
- And, of course, sentiment will also be impacted by events in the political and economic spheres
The key factor, as I learnt when trading in oil and product markets in Houston, Texas for ICI is that “the trend is your friend“. Traders will delight in short-term volatility, and try to catch the various up and down movements. Genuine investors will ignore these and instead focus on the long-term trend. For them, the Great Unwinding concept has been very helpful in understanding the outlook for oil and the US$ – the 2 key components of the Unwinding.
Another useful guide over the past 2 years has been the concept of “higher lows and lower highs“, which helps to highlight major turning points, as the dotted trend lines illustrate:
- Oil prices have never returned to the August 2014 level, and they made new lows once the “oil rig rally” ended
- The US$ has essentially been trading within tram lines over the past 18 months – preparing for another breakout
This pattern of “technical trading” is, course, exactly what guided us during the previous oil market rally from 2009 – August 2014. Readers will remember the above chart from 21 August 2014. Its value was that it enabled us to map the battle between the financial players and the fundamentals of supply/demand, as I noted then:
“Thus the oil price is finally starting to fall out of its triangle:
- 10 years of historically high prices has led to major new investment, which is finally starting to come online – not only in oil, but also in gas and other energy sources
- At the same time, central bank lending is finally starting to reduce in China and the US
- 10 years of high prices have also led to demand destruction via greater efficiency and conservation efforts
“The result, as the IEA note, is that we suddenly find we face a supply glut.
“So the chart is telling us that the financial players are now retreating from the market. In turn, this means physical supply/demand levels will come to drive the process of price discovery once again.”
There was never any real logic behind the story that the US drilling rig decline would lead to lower oil production, or that an OPEC/Russia production freeze would cause markets to rebalance. But in today’s world of high-frequency trading, driven by algorithms, most traders focus on making a quick profit rather than logic. Many senior oil company executives are also happy to talk the market up, hoping this will boost their company’s share price.
But today, we seem to have once again reached the fork in the road, with massive oil surpluses now emerging. As Reuters noted on Friday:
“The levels of diesel, gasoline and heating oil in storage tanks in Europe this week are so high they are causing delivery backlogs and are casting doubt on whether demand for oil to be refined can be sustained….storage tanks for diesel and heating oil are already so full in Germany, Europe’s largest diesel consumer, that barges looking to discharge their oil product cargoes along the Rhine are being delayed, sources told Reuters….
“The sheer volume of gasoline in the system, despite surging demand, has more than halved gasoline refining margins in Europe over the past two weeks to just $5.75 per barrel on Thursday, a fifth of where they stood at the same time last year”
The US$ looks similarly ready to make a move out of its tramlines, as the Eurozone debt crisis re-emerges into public view. The key is the Italian banking system, which appears close to collapse. I will look at this shortly.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 54%
Naphtha Europe, down 56%. “European gasoline refinery margins have come under increasing downward pressure on an escalation in Atlantic Basin inventory levels.”
Benzene Europe, down 55%. “Other players had a more bearish outlook for oil and energy numbers in the coming weeks, and expect that to pull benzene prices down.”
PTA China, down 39%. “Sentiments were bearish, as a major Chinese PTA producer continued to sell large volumes of Chinese Yuan (CNY)- denominated PTA cargoes this week, with the selling frenzy continuing from last Friday”
HDPE US export, down 33%. “Some Chinese traders opted to stand on the sideline as they hold comfortable inventory levels and an uncertain outlook of the market”
US$ Index, up 18%
S&P 500 stock market index, up 9%