Macro and Markets

Kahn analyzes economic policies for an integrated world.

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Headquarters of Sberbank, one of the Russian institutions under U.S. sanctions
Headquarters of Sberbank, one of the Russian institutions under U.S. sanctions REUTERS/Sergei Karpukhin

Have Sanctions Become the Swiss Army Knife of U.S. Foreign Policy?

The Congress takes an important, positive step to reinforce Russian sanctions, but are we at risk of overusing the sanctions tool? Read More

French Elections and the Remaining Populist Challenge
Emmanuel Macron received a strong endorsement from French voters in yesterday’s second round election, winning around 66 percent of the vote.  While abstentions were up from the last election (an estimated 26 percent), early returns suggest broad-based support for Macron and his centrist, pro-European message. Attention now turns to the June 11th and 18th parliamentary elections, where President Macron and his newly formed political movement En Marche! face uncertain prospects in their effort to gain a workable parliamentary majority. The result was expected, and consequently the market response was muted though positive.  Clearly a major tail risk that would have rattled investors has been avoided, and markets view favorably Macron's economic program centered on business, labor and fiscal reform. European leaders were visibly relieved, and rightly so, as a Le Pen win would have presented a deep and immediate challenge to the future of the European Union. But I am less sure that the obverse is true, that a Macron win represents the zenith of the populist threat. As I mentioned after the first round, a common refrain during the recent IMF Meetings was the idea that, with the electoral challenge from radical populists in the Netherlands and France defeated, and assuming continuity in German elections this fall, Europe would be ready to make a strong push towards greater European integration, most importantly on economic issues. It also is assumed that Macron will take a strongly pro-EU line in the Brexit negotiations, though there again it isn’t until late this year or 2018 that the significant decisions will be made on the terms of the Britain-EU divorce, as well as what follows. I am more convinced by the argument that the nationalism and populism that has spread across western industrial countries will remain a potent force in Europe, even as the immediate threat as been pushed back, until Europe’s leaders, policies, and institutions can deliver a more optimistic economic future (with more broad-based, inclusive growth and a more integrated Europe that is better able to respond to shocks) to more of its citizens. While immigration and security top polls now as the central concern of Europeans, a decade of economic growth has left many Europeans pessimistic about their long-term economic future.  In this scenario, these pressures are likely to fester, and potentially constrain even European-mined politicians to adopt more nationalistic policies. While a France-led Macron may become a leading voice for more Europe, forming a consensus across Europe (including, most importantly, those countries with the fiscal capacity to finance greater integration) on pro-growth, pro-Europe policies seems increasingly challenging.  European populism appears, as nicely put elsewhere, to have entered the awkward adolescence years: “able to borrow the car but not own it, have an influence on the household but be too young to run it.” The election could have one immediate impact on international economic relations, as there are reports that Macron could look to IMF managing director Christine Lagarde, Managing Director of the IMF, as his prime minister. That would be good choice for France, but would confront world leaders with tough questions about the future direction the IMF.  Legarde had appeared to be building good relations with the new U.S. administration, and while the convention of European leadership of the IMF has held until now, a succession discussion could provide an early test of the organization’s relationship with a new U.S. administration that has entered office suspicious of multilateralism.
United Kingdom
Brexit: Now for the Hard Part
The weekend’s European Union (EU) Summit provided little love for UK prime minister Theresa May. Leaders approved a tough opening position in the upcoming Brexit negotiations, and warned against “completely unreal” expectations of a swift and favorable deal. EU negotiators will seek early agreement on the terms of exit (including citizen’s rights and the financial exit payments) before moving forward on a long-term trade agreement, while the British government seeks agreement on all three tracks together—“divorce”, transitional terms, and the long-term deal—by March 2019. Hard talk at the start of the negotiation should not be a surprise, but in some respects this past week does reflect a turning point. In my May monthly, I review the state of the negotiations and argue that the hard part of Brexit begins now. In particular: While the UK economy has held up impressively well to date, the longer-term economic costs of Brexit are becoming more apparent. The primary cost of Brexit was never to be measured by short-term dislocation, but rather through the long-term reduction in investment and reduced efficiency that comes from lost access to Europe’s common market and a less prosperous economic future. Economists estimate that the loss in UK gross domestic product from Brexit ranges from 1.5 percent to 9.5 percent, attributable to increased barriers to trade and migration and to the financial services sector shrinking as a result of limits to cross-border activity. The new relationship between the United Kingdom and the European Union, as well as the rest of the world, will take years to work out. An extended transition to an uncertain future will further stress UK and EU economies. The election cycle—most important, the ongoing French elections and German elections in the fall—makes it impossible for leaders to make tough decisions on the future of Europe. After those elections, and allowing some time for preparation, negotiators will have roughly nine months beginning early in 2018 to make the critical decisions on the path forward, in order for the exit agreement to be confirmed and implemented by the March 2019 deadline imposed by the Lisbon Treaty. The disconnect between political and economic timelines remains a significant, and underappreciated, cost of Brexit. Long-term investment decisions take time, as does the relocation of jobs and production to the continent, and the regulatory approval process adds to the challenge. All this suggests that, although investors have been patient and there has not been substantial movement of jobs to the continent so far, the pressure to make long-term decisions will intensify in the coming years, leading to investment and job shifts that could, in turn, affect the politics of Brexit. The challenge of launching a fundamental renegotiation of Britain’s economic and political relationship with Europe—a process that could take a decade—is straining political consensus in the United Kingdom and on the continent. Brexit will produce a Britain that is poorer and less of an economic and financial power than if it had remained in the European Union. At the same time, the Brexit vote adds to the populist and inward-looking centrifugal forces pulling at Europe. A chaotic Brexit remains a serious risk.
Is It Time for Markets to Worry About Political Risk?
Jens Nystedt is a senior portfolio manager and head of sovereign research on the Emerging Markets Debt team at Morgan Stanley Investment Management.  Nearly 100 days into his term, President Trump faces a daunting array of international political challenges. Growing tensions between the United States and North Korea, U.S. missile attacks in Syria, and rising uncertainty in the Middle East now sit at the top of an extraordinary full presidential inbox. Meanwhile, this past weekend’s elections in France, though well received by markets, again raise questions about the future of the euro zone, and the post Brexit outlook for Europe more broadly. While the first year of a new U.S. administration often sees a spike in geopolitical tensions, there is an extraordinary sense of disorder to the global outlook at this time. Against this backdrop, financial markets have remained impressively resilient to political risk, bolstered by accommodative macroeconomic policies in the leading countries and confidence that the worst outcomes will be avoided. Despite some recent wobbles, U.S. equity markets have sustained a significant portion of their post-election gains, and markets globally have absorbed news of rising global tensions, electoral uncertainties, and the beginnings of a monetary policy tightening cycle in the United States. Such confidence is bolstered by historical evidence that we review below showing that, looking back over the entire post-war period, markets most of the time have bounced back quickly from political shocks. We highlight the role of a supportive economic and political framework in providing reassurance at critical times. But there are exceptions, and certainly the current environment has the capacity to generate lasting dislocations. Could this time be different, and could we be entering a period where markets react more sharply than in the past to rising political risks? When do financial markets react to geopolitical events? As a general observation, financial markets, especially the U.S. stock market, have tended to only temporarily react to geopolitical shocks and it has typically proven unwise to “sell” a shock after the fact. Recreating and updating a list of major “Shocks to the System” since the start of World War II by S&P Capital IQ and their impact on the S&P500, we note that your typical geopolitical event resulted in a median loss of 3.4 percent until the bottom was hit and the U.S. stock market recovered to pre-event levels within a median of five days. Hence, were you lucky enough to be short/underweight the U.S. stock market going into a surprise geopolitical event, these events have often been buying opportunities after the initial sell-off. This in our view reflects the market’s ability to see-through the event and remain focused on the overall economic health of the company, U.S. or global economy, and the pricing-in of the anticipated likely policy response, such as rate cuts (after the 9/11 attacks) or a surge in fiscal spending on military equipment. Consequently, it is useful to keep in mind that the market is conditioned towards “buying-the-dip” in present circumstances, which will only make the eventual sell-off larger if a new shock is large enough and the expected policy action doesn’t materialize. We could easily see a two-step sell-off in such a scenario. As the below table shows, even during recent crises, such as Russia’s invasion of Ukraine in 2014/15, U.S. stock markets either did not react or recovered fully between a day and two weeks. Looking at the above table in more detail, market declines and recoveries since World War II, suggest the following ingredients for a more marked and lasting impact on financial markets (here again looking at the U.S. stock market): 1. The event needs to be a major geopolitical event or directly implicating the United States in a significant manner. This includes major wars or significant political events such as the Nixon resignation, which led to a re-assessment of the role of the U.S. role in the world. A longer lasting negative market reaction is more likely if multiple shocks occur simultaneously or if U.S. and/or global growth was weak to begin with. 2. Lack of compensatory policy action. Even during the Cuban Missile Crisis, its quick resolution limited the market sell-off to a day or two and the markets only took three days to recover. Possible compensatory policies can include economic policies, such as an accommodative central bank or a fiscal authority that (if it has the capacity) shifts to a more expansionary policy to buffer demand. It can also include broader political statements or international policy coordination that provides reassurance that policymakers are addressing the problem and that “the system works.” It’s worth emphasizing that these buffers work differently across countries. From this perspective, we have concerns about the capacity of some industrial country governments to respond quickly against the backdrop of rising nationalism and diminished fiscal space (and of soft-power institutions such as the G20 to reach consensus when coordination is needed), but take comfort that many (though not all) emerging markets are entering this period of turbulence in better shape than in the past, having built international reserves and otherwise strengthened macroeconomic policies in the recent decade or so. 3. Events that have a financial market impact, or a potential impact, on oil supplies score higher as well as events that could threaten important trade routes. The OPEC oil embargo had a very small market reaction initially (as shown in the table), but the First Gulf War had a more significant impact. Looking forward, an open question is whether the changing role of energy in the U.S. economy, and increased energy independence, tempers the force through which this channel operates. 4. Repeated events such as the Ukraine/Russia conflict (or events such as North Korean missile tests or increased Israel/Palestinian tensions – not in the table) have had a diminished impact on global financial markets over time. The market tends to become increasingly unaffected by repeat events, which may prove unwise in case repeated events are a precursor to a bigger shock. What are the risks that foreign policy experts worry most about? Each year, CFR’s Center for Preventive Action carries out a survey, and their most recent Preventive Priorities Survey (PPS) identified seven ‘top tier’ risks that makes for fascinating reading in terms of what are among expert’s top international concerns for 2017. Among the top concerns were: (i) A military confrontation between NATO and Russia; (ii) A crisis in North Korea, as might follow an ICBM test launch; (iii) A highly disruptive cyberattack on U.S. critical infrastructure; and (iv) a mass casualty terrorist attack. Moreover, the repeated nature of the PPS flags not only what is on the current year’s list, but also what risks were downgraded, such as the political implication of the European refugee crisis (which may be too early given the E.U.’s political calendar this year). Drawing on the historical experience provides a guide to how markets might react, recognizing the extraordinary uncertainty that each of these scenarios present. Each of these events have the potential to cause a material disruption to U.S. markets. Given today’s globalized, integrated financial markets, a conflict with Russia could lead to a ‘severe flight to safety’ into the U.S. dollar, a spike in oil, a sharp decline in the euro, even with quick coordinated monetary policy action to cut already very low rates and intervention to support the Euro.  We suspect that renewed Quantitative Easing, or QE, is unlikely to provide substantial support. The other risks identified may be more difficult to quantify, and drawing lessons from the past is more challenging, but each have the potential to provide broad and long-lasting disruptions to the global economy.  A highly disruptive cyberattack on the United States, for example, especially if targeting the financial system and going beyond a single company, is likely to have major financial market repercussions. This is uncharted territory for global markets, though the closest analog is probably the Lehman crisis due to its unforeseen nature and that it affected the core of the payments infrastructure for the U.S. and globally. Spillovers and contagion would be significant, but again policy could ameliorate some of the negative consequences. A negative market reaction is likely to persist if investors are concerned about a new U.S. administration facing its perhaps first geopolitical test. However, if a war develops in the Koreas, this would no doubt be a major financial market event. To add a widely discussed scenario in the market, tension between China and the United States, or between China and Japan, that result in military action would have a major market impact, especially given the Trump administration’s anti-China focus, the interruption to key global trade routes, and the uncertainty regarding the new administration’s reaction function. What are the risks the markets are the most worried about and are they pricing these in? The new administration has moved quickly to reduce negative geopolitical tail risks vis-à-vis China (re-affirming the one-China policy and choosing not to cite China as a currency manipulator) and reversing course on its earlier criticism of NATO. Market spreads in Korea and in the Baltics, where market anxieties would be expected in prices first, have remained contained. Even in France, spreads rose in advance of the election but not commiserate to the odds of an anti-EU result as reflected in recent polling. Hence, it is hard to identify a material risk premium in markets attached to policies of the new U.S. administration or to the risk that broader anti-globalization pressures lead to material conflict on trade or financial issues. So far it has if anything been quite the opposite. Looking at Russian assets, given the recovery in oil prices and the election of Trump, Russian financial market assets, foreign exchange, interest rates, and equities have all rallied on better fundamental news and in the hope of an eventual reduction in sanctions. In summary, financial markets, as exemplified by the U.S. stock market, react typically only to a limited extent to typical geopolitical events, and are unlikely to move significantly ahead of events on rising tensions. If there is a negative reaction in the U.S. stock market it is typically very quick, but the recovery often is quick too, especially if there is convincing compensatory policy action. Market confidence in policy action is crucial, particularly in the major countries to reduce the systemic consequences and provide reassurance about prospects for global markets. If this confidence is lost, we could be entering a more uncertain period for markets and for the global economy.   The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. The views and opinions are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.
  • European Union
    France After the Election: What Next for Economic Policy in Europe?
    French election results show Emmanuel Macron in first place with 23.9 percent of the vote and Marine Le Pen in second with 21.4 percent, setting the stage for a run-off election on May 7. Early polls show a comfortable edge for Macron, the pro-E.U. former economy minister who ran on a campaign of ambitious economic reform including labor market deregulation and lower corporate taxes (though there will be questions about where supporters of Jean-Luc Mélenchon will land, or whether they will vote at all). While the result was expected, markets had become quite jittery in recent days and, unsurprisingly, rallied as results came in. The euro this morning is 2 percent stronger, reaching a five-month high at 1.09 to the dollar, and gold as well as other safe-haven investments have sold off. Investors are clearly relieved with the result that put Macron into the second round. But political risk is likely to remain an endemic feature in European and global markets, and European policymakers face a full calendar of challenges over the course of the year without a compelling vision about how to address the populist pressures sweeping the region. What comes next? Of the electoral challenges facing Europe this year, the French Presidential elections were the focus of markets given the importance of the French economy and Marine Le Pen’s call for France to leave the euro. Even if she were to prevail in the runoff, polls suggest a referendum on “Frexit” would fail and that her party would fall well short in mid-June parliamentary elections of the super majority necessary for constitutional changes. Still, a Le Pen victory would have caused economic tremors throughout Europe and called the future of the euro into question. From this perspective, Macron’s strong showing, against the backdrop of EU flags at rallies and in line with the polls, is an important stabilizing result. Now, market attention will now focus on this fall’s German elections, as well as possible early elections in Italy and Greece. In these latter two cases, politics will be affected by the resolution of economic problems—banks in Italy and debt in Greece—that could tell us a lot about Europe’s capacity to come together and solve EU-wide problems in the current environment. At this week’s meetings of the IMF and World Bank, we heard contrasting visions of the future course of economic policy in Europe. I repeatedly heard from European economic policymakers—though I am not sure whether this is hope or real belief—that these elections open a window for greater economic reform and more integration. The idea, as I understand it, is that, should pro-European leaders be elected in France and Germany, the stage would be set later this year for a new compact between the two largest countries in the Eurozone to re-energize the process of monetary and financial union, and address aggressively other challenges facing Europe including security, migration and Brexit. The converse argument, which I find far more compelling, sees a European economy that will continue to be constrained by strong populist and nationalistic pressures. Those pressures, as many have written, have their origin in a long period of poor economic performance reflected in low growth, high unemployment, and unaddressed dislocations from technology and integration. My concern in this context is not only the rise of rejectionist candidates in elections, but also that populism increasingly constrains mainstream politicians, a challenge compounded by the Brexit vote and the difficult negotiations that lie ahead. Polls now show that security and immigration have become the disruptors providing the fuel for the recent rise in discontent with mainstream policies, policymakers and institutions. From this perspective, it is possible to see yesterday's vote, where more than 40 percent voted for Marine Le Pen or Jean-Luc Mélenchon, and representatives of the two leading parties finished third and fifth, as a strong repudiation of the status quo. Europe’s economic future remains uncertain, even in the midst of a modest cyclical recovery. The IMF projects growth in the euro area at 1.7 percent this year and 1.6 percent next year, (1.4 and 1.6 percent in France), which should allow for the continued slow reduction in still too-high unemployment rates. Mildly expansionary fiscal policy, easy financial conditions and a weak euro all support activity. But the IMF cautions that without further reform the “medium-term outlook for the euro area as a whole remains dim, as projected potential growth is held back by weak productivity, adverse demographics, and, in some countries, unresolved legacy problems of public and private debt overhang, with a high level of nonperforming loans.” I still believe that a durable cure for the winds buffeting Europe requires a better economic future—and in the current electoral environment it is extraordinarily difficult to convince voters across the region that greater European integration is the way to get there.
  • United States
    Currency Wars: China Escapes a Manipulation Charge
    On balance, the report reaffirms that, while trade and not exchange rates is likely to be the primary battleground for U.S. economic relations in the future, exchange rates remain a flash point.