Topic/Theme Reports

Country Risk “Crap-shoot” Commentary

Scott MacDonald, PhD

November 7, 2016

Short-Term Outlook: The main drivers for debt and equity markets are U.S. electoral politics, macroeconomic data flow (U.S./Europe/China), and corporate earnings. Beyond U.S. political uncertainty (which could linger post-November 8th depending on the closeness of the outcome and the intention of the loser), the next three short-term issues are announcements of the next administration's appointments for key cabinet posts, the Italian referendum (December 4rd), and the next FOMC (Federal Open Market Committee) on December 13-14.  General expectations are that Secretary Hillary Clinton wins, and real estate mogul/reality TV star Donald Trump accepts his defeat. At that point, President-elect Clinton starts announcing a mixed moderate/progressive cabinet (with an emphasis on half of the new top posts going to women), that the reform referendum will pass in Italy, and that, barring any shock to the markets from the elections, the Federal Reserve will resume raising interest rates.  If Donald Trump wins, the dynamic could radically change – and much will depend on his acceptance speech and if he reiterates his anti-trade rhetoric, equity and bond markets will be hit.  Currencies will be in a tug of war and the USD could strengthen.

As of the close of business on Friday, November 4, 2016

10-Year US Treasury: 1.782%

VIX Index: 22.51

Gold: $1,289.60

Oil: $45.11

USD/JPY: 104.153

EUR/USD: 1.1103

Short-term worries - Turkey's politics are heading toward more authoritarianism with the recent purge that followed the failed August coup and this past week's arrest of leaders of the pro-Kurdish political party HDP. This action is likely to add to political turmoil in Turkey. It is also a bad signal that politics is more important than the economy for the Erdogan administration. In fact, President Erdogan will continue his mission to reshape Turkey into a more Muslim country (though not a theocracy) and a more significant regional power whose national interest are less and less in sync with the European Union, the U.S. and NATO.

Indeed, late last week, Erdogan stated: "We are anxious that Germany, which has been taking terrorist organizations like the PKK (The Kurdistan Workers Party), DHKP-C (The Revolutionary People's Liberation Party) under its wing, is now becoming a backyard for FETO", a term used by Ankara to refer to supporters of US-based cleric Fetullah Gulen. Erdogan said Germany had long harbored militants from the PKK, which has waged a three-decade insurgency for Kurdish autonomy, and far-leftists from the DHKP-C, which has carried out armed attacks in Turkey. The EU designated both groups as terror organizations.  The comments did not go over well in Berlin and reflect a steady deterioration in relations.

The other short-term worry is the melt-down in Venezuela, where the political polarization is acute, the economy is in free-fall, and debt management is stretched. According to the IMF, real GDP is expected to shrink by -10.0% in 2016 and another -4.5% in 2017, while inflation is forecast to go from 476% to 1660% over the same period. With little chance of a resolution in sight on the political front, a substantial decline in foreign exchange reserves, and no major hike in oil prices on the horizon, chances for a default on the country's state-owned oil company (PDVSA) bonds is high. The government faces debt payments of $13 billion over the next year, but international reserves have fallen to a little under $11 billion (much of it is in gold).

Lucky 7s: Fear, Phobia and Risk Factors

1. U.S. Elections: Democratic candidate Clinton leads in national polls by a narrow margin over Republican Trump.  The expectation, based on state by state polls, is that Clinton will squeak by, but the chance of a Trump victory cannot be ruled out.  That said, it appears that market bets are on Clinton. The risk is that Trump wins and in his acceptance speech sticks to his protectionist rhetoric.  In that case a major market unwind would be a probability. Clinton is perceived as a status quo candidate, which markets prefer, though her administration would probably bring greater regulation, more pressure to break up the large banks and higher taxes on business. 

2. U.S. Macro:  This concern is directly linked to the first item on the Lucky 7s list. We have had a long economic recovery since 2008; while the U.S. recovery can continue in a sluggish mode of sub-par real GDP growth, a number of problems clearly exist, including the housing market, a build-up in debt, and weak industrial production.  Trade is another concern. After Tuesday, the winner will need to address the economy. 

3. Italian Referendum: This could be Europe's next crisis if the standing center-left government of Prime Minister Renzi loses big to the opposition on whether to streamline the reform process. The opposition favors a return to the lira, lower taxes and higher social spending. The vote occurs on December 4th and polls indicate that it is very close.   

4. Brexit: There are many unknowns here and the High Court's recent decision that the process has to go through Parliament adds one more factor.     

5. Trade Protectionism: Global trade is stalling and the rise of protectionism has an echo to the 1930s. According to the OECD, at the end of Q2 2016, the G20 countries’ total international merchandise trade grew modesty, seasonally adjusted and expressed in current US dollars.  This was the first increase since early 2014, but remains significantly below post-crisis highs. Exports rose by +1.5% and imports by +2.0%, following seven and eight consecutive quarterly falls, respectively, mirroring the rise in oil prices (to almost $50 a barrel in June 2016, compared with around $35 a barrel in December 2015). Looking ahead, trade and currency policies in major economies is going to be of greater importance, especially if growth slows further.

6. European Banks:  German and Italian banks have been in the press over the past year and many of the problems they face in terms of capital adequacy and profitability remain a concern. Deutsche Bank is hardly the only troubled institution and negative interest rate policies are not helping bank bottom lines.

7. China's credit bubble: A considerable amount of credit has pushed up parts of the Chinese economy; some of these bubbles are beginning to deflate and that portends slower growth.  Analysts at ratings agency Moody’s, writing in May, warned that China could suffer “a prolonged period of sub-optimal economic growth and persistent deflationary pressures, or possibly even economic stagnation.” The growth slowdown is also marching hand-in-hand with the consolidation of power into the hands of President XI, who is obviously giving thought to the potential for social unrest if growth slows too much. 

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