The Meaning of the System's Resilience for Investors

There is much doom and gloom. Despite the recovery from the Great Financial Crisis, there is a high element of economic anxiety. It is not just about economics.  Political developments are worrisome.  We are told by various pundits in the media that democracy is dying.

Six months ago, we argued that the consensus narrative under-estimates the resilience of the system.  Recall that then many feared that the so-called populist-nationalist wave that saw the UK vote to leave the EU and the US vote to elect Trump was going to sweep across Europe.

For several years, many in the media have been talking about currency wars and beggar-thy-neighbor policies of competitive depreciation.  The occasional talk by the new US administration threatens a new front.  Even more seemed to believe in the demise of the European Monetary Union.  The UK's vote to leave (in a non-binding referendum) was going to be the catalyst.  The barrier to exit was broken.  Others would join in regaining their sovereignty.  Nobel-prize winning economist Stiglitz joined a crowded field in providing a new volume on the demise of the euro (at the hands of Germany and Italy).

The UK journalist Paul Mason told us in 2015 that "end of capitalism has begun" at the heart of emerging postcapitalist era was the revolution in information technology.   The explicit call for utopian thinking has been superseded it appears.  Now the same journalist, mostly citing developments in China, Russia, Turkey, Hungary and the election of Trump, as evidence democracy is dying.  Others may not go quite that far but are remain concerned about the "democratic deficit." The rise of nationalism, opposition to legal immigration (no one is really in favor of illegal immigration), and the increasing rigidities to social mobility appears to be contributing to latent and obvious racial and ideological tensions.

Yet we remain impressed with the resilience of the economic system and democratic institutions.  The populist-nationalist movements have been denied national victories in Europe.  UK Prime Minister May has confirmed that the nonbinding resolution to leave the EU would be treated as authoritative.  After initially rejecting the advice, she did seek a popular mandate and lost her parliamentary majority.  At the same time, some of her rhetoric about capitalism and social obligations sound more than a social democrat that the Cameron-Osborne wing of the Tory Party.

Seventy-five years ago, the US Supreme Court allowed the left-center populist President intern American citizens of Japanese descent.  Now the judicial system is acting as a check on President Trump's immigration plans.  Forty years ago, the National Socialists (Nazis) were marching in Skokie, Illinois, where many Holocaust survivors resided.  Home-grown terrorism has always been more of a threat to Americans than foreign-sourced terrorism.  The existence of the KKK or Nazi's does not mean democracy has ended, and to the contrary, the widespread outrage suggests that more than embers remain.

Trump, like his immediate predecessors, promised to cite China as a currency manipulator.  He has not, anymore they did.  He threatened to pull out of NAFTA and instead will start negotiation later this week to update it, apparently building on some of the heavy lifting of the Trans-Pacific Partnership.  The withdrawal from those negotiations was not simply a Republican decision.  As Trump noted at the time, both Clinton and Sanders were also opposed to the TPP (in the campaign).  The investigation of US steel imports on national security grounds has reportedly been completed, but apparently, the administration has been reluctant to make public its finding or announce fresh measures.

The constitutional system of checks and balances is working.   As Bismark warned,  one should not see the way laws or sausages are made.   While the Republicans have a majority both houses of Congress, they have been unable to do very much.  They have sought to exploit the rules that allow that to use a simple majority, but this has blocked by the differences within the party.  One of the few issues that Republicans and Democrats have worked together was on the new sanctions against North Korea, Russia, and Iran.  The measure limits the President's ability to backtrack. As has often been the case, Congress also moved to prevent recess-appointments by the President.

There are countless other ways to measure the resilience, but our point is that the doom and gloom narrative of the end of globalization, the end of democracy, and the demise of the EMU have been grossly exaggerated.  The occasional political tension that arises tends to be short-lived and provide opportunities for trend follows as well as value investors.  The Russell 1000 Value Index  (RLV) has fallen in only three weeks since the end of May.  Last week it fell by 1.85%, the most since March.   A five-month peak had been reached on August 8, when it recorded a key reversal.  It subsequently fell to the 50% retracement of the rally since May and is recovering sharply today.

We suspect that the resilience of the system means that investors ought to stick to their knitting.  The economic laws of supply and demand have not been repealed.  Politics are often messy, and representative government is no utopia.  While monetary and fiscal policies shape the investment climate, politics is most often a transitory influence.

There are a number of events in the coming weeks that investors will likely find more significant than the political events that are dominating the headlines today.    The Jackson  Hole confab will draw attention. ECB President Draghi will speak at the venue for the time in three years, and many are hoping for clues to the trajectory of ECB's unorthodox policy.  September sees the ECB meeting, where 2018 purchases are likely to be announced.  At its September FOMC meeting, the Fed is expected to announce it will begin allowing its balance sheet to shrink slowly in Q4.  There is a small chance that the BOJ lifts the target for its 10-year JGB.  Germany and Noway hold national elections in September.  The US needs to lift its debt ceiling (or face missing a debt payment) and renew spending authorization (or face a government shutdown).

The conventional narrative has abandoned divergence in favor of new convergence; we are skeptical.  First, we note that it is likely that if the Fed begins its balance sheet operations in Q4, by the middle of next year, the balance sheet will shrink by $180 bln (modest on a $4 trillion plus base).  The ECB's balance sheet will expand by about 180 bln euro in Q4, and we estimate another 180 bln euros in H1 18.  Second,  we suspect the Federal Reserve will hike rates 2-3 times by the middle of next year.  During this period we do not expect the ECB to hike its minus 40 bp deposit rate.

Third, much is made that US President Trump lacks broad public support.  However, since he lost the popular vote, but won the decisive electoral college vote, the divided nature of the American electorate is well known.  What is new is how fast the newly elected French President has lost support.  Macron's standing in France is lower than Trump's in the US.  This is important because it would seem to jeopardize his agenda, which is key to renewed vigor in the Franco-German relationship and addressing the simmering structural challenges in EMU.

Japan's Prime Minister Abe has also fallen out of favor amid several domestic scandals and allegations.  A cabinet reshuffle a couple of weeks ago stemmed the bleeding, but the Cabinet's support is now just above Trump's support.  Italy has an unelected Prime Minister (the fourth since the last parliamentary election).  The new electoral law is not in place yet, but a loose affiliation of center-right parties are polling ahead of the center-left.  In the UK, there is talk of another cabinet reshuffle ahead of the Tory Party conference in Q4.