The farce that has developed out of the UK’s decision to vote for Brexit would be funny if it were not so sad. Sad to see a proud nation like the UK become the laughing stock of Europe, especially at a time when Europe desperately needs to focus on pulling itself together. It is under threat from all geographies. The US, Russia and China are all nibbling steadily at its economic prosperity. It is a soft target with somewhat of an identity crisis. It tries to act as a federal State but lacks the cohesive powers and decision-making.
Not surprisingly the economic performance of the EU has suffered. As much as French President Emmanuel Macron may call the upcoming European elections as “decisive for the future of our continent” in his open letter to European citizens, it is economic prosperity that citizens continuously crave for.
It is a clear sign that things are not right when a government, Germany in this case, can sell 10-year government bonds at an average yield of minus 0.05 per cent. Investors in these instruments are guaranteed a loss on their capital over the period preferring a safe return of their capital, albeit at a marginal loss, rather than opting for a return on their capital.
This comes on the back of some terrible economic statistics from Germany where manufacturing shrank at the quickest pace in over six-and-a-half years. Perhaps a reflection of the uncertainty emanating from Donald Trump’s trade war positioning with Europe, it is also a reflection of the political uncertainty in Europe.
The European Central Bank has acknowledged the economic weakness that appears to be gripping the bloc and has now changed its policy stance, looking at ways to boost economies once again. With eurozone GDP expected to reach just one per cent this year, according to OECD estimates, and 1.2 per cent next, fiscal stimulus should come back to the discussion table, especially since monetary policy is perhaps as loose as it can get.
It is sad to see a proud nation like the UK become the laughing stock of Europe
It may be counterintuitive therefore to look at equity markets and see that against a background of weakening economic outlook, growing political uncertainty, a Brexit farce and Trump threatening a trade war on Europe, markets have performed so well. As at the close of business on March 27, the STOXX Euro 600 Index is up 11.74 per cent since January 1.
Some of this move is a reaction to the significant downward move in equity markets witnessed in Q4 2018. But it is also a realisation that once again the move to push interest rates higher is being postponed. Interest rates will remain low for even longer. A consequence of this is that the search for yield has resurfaced. This search has propelled both equity and bonds market higher as investors chase prices trying to lock in the little yield that is left on the table.
This is not a situation that can persist for a significant length of time, however. If economic activity does not pick up soon, or at least the outlook does not improve, price action between the equity and bond market should dislocate. Equities should move lower reflecting a weaker earnings growth outlook as companies struggle to grow their top line. Meanwhile bond prices will remain supported by investors search for yield.
On the other hand if the economic outlook does improve bond prices should start to stutter. After the recent strong rally we are at an important junction. The question is, which direction do we take? One part of the market thinks that a recession in the US is on the way. A reasonably reliable forward indicator of this, the US Treasury yield curve, partially inverted earlier in the week. If a recession is indeed on the horizon in the US, then Europe needs to look to domestic demand to bolster activity.
A move away from balanced budgets and thus an increase in government spending is one way of doing this. Many prominent economists have been calling for this but Germany continues to hold steadfast. Meanwhile ECB president Mario Draghi is actively looking into his box of tricks to find a new magic wand that will breath a fresh lease of life into the European economy. I wouldn’t underestimate him.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
David Curmi is managing director at Curmi and Partners Ltd.