US political outlook 2021
· The real choice in European and especially German politics is whether to support eurozone integration
· What’s in store for Emmanuel Macron in 2021
· A Brexit deal frees the UK of Brussels control – what is the future
· What to expect for the UK economy this year
· A wave of corporate insolvencies is coming to the EU
· What’s in store for the ECB in 2021?
· The EU between the US and China
· The politicisation by Brussels of Covid vaccines could well turn into an economic and political black swan event – with a huge price to pay
· Manias often end around the turn of the calendar year
· Fiscal policy may become sufficiently stimulative to reverse the direction of travel for equilibrium real interest rates.
US political outlook 2021
– Biden centrists versus progressives
– Covid response, new lockdowns for Biden PR
– Stalemate in House and Senate
– 1 maybe 2 more stimulus bills
– Stimulus fight, targeted projects
– Infrastructure Bill problems(progressives block)
– Climate initiatives versus on-shoring desire
– Rogue Fed/Treasury continue to pump equities
– EU Honeymoon short lived due to Nord Stream II and potential investment deal with China
– Mideast & African tensions
– Dollar rise in January, fall rest of year
– Focus on rolling back Trump policies hamper economic progress
– Lockdown politics interference in supply chain
Biden centrists vs progressives:
The Biden presidency will be preoccupied by internal quarreling between centrist Democrats looking for bipartisanship and progressive instigators looking to balance between trying to gain power within the Democratic Party and act against any and all GOP initiatives to satisfy its base. Pelosi’s speakership is certainly in question and her ability to round up votes for legislation will be a constant battle as the Dem majority is razor thin.
Stalemate in House and Senate:
As the Dems in the House battle internal demons, the Senate is still up for grabs with Georgia runoffs still to be settled. As of today, we expect the GOP to win both races which would certainly stall any Biden climate initiatives and roll backs of tax cuts. Unless the Dems win both seats, there is little chance for a pro-Biden Senate.
Now, Albert’s calculations suggest the following:
Perdue squeaking out a 1.1% win, and
Loeffler is up by 2.1%
Why the difference with the above polling average? Well, bear in mind a couple of things, given the early vote share:
· Republican voters do typically vote in person on the day;
Covid response, new lockdowns for Biden boost
Covid lockdown 2.0 is nearly upon us. The Europeans are in full lockdowns, the UK has a more ‘infectious’ strain, which is most probably long active in most other countries, along with numerous other mutations revolving around the globe. This will prompt stricter lockdowns by the Biden administration as an attempt to control the narrative of their actions leading to vaccination drives, reopening plans and ‘patting themselves on their own backs’ over their handling of the situation. The media coverage will tell you everything you need to know, as it will be very complimentary of any and all rhetoric coming out of the new White House.
Rogue Fed/Treasury continue to pump equities
As further lockdowns are implemented and the economy stutters, the Fed/Treasury will resort to its March 2020 actions of pumping certain equities to keep the markets afloat. They are fearful of Trump gaining credit for the past 3 years of economic expansion, the effect of which would put the Biden administration under a microscope leading to a 2022 Dem House majority loss and a resurgent 2024 Trump. The two easiest equites to pump will be Adobe and Facebook going forward.
Dollar rise in January, fall rest of year
Lockdowns will inevitably cause supply chain disruptions and manufacturing inefficiencies across the globe, but specifically in Europe and the US. This could lead to a short lived pop in the DXY to 95 in mid-January, however I expect the rest of the year for the dollar to fall, as new stimulus bills are passed and the Fed actions push the dollar into the low to mid 80s.
Climate initiatives vs On-shoring
The initial signal of the Biden administration is to accommodate global climate change policies to appease the Democratic base and the folly of acting as a global leader in the space for foreign policy objectives. The Paris Accords have no enforcement mechanism and nations self-report data and goals. This does nothing but hamper US manufacturing, thus making the Biden’s administration goals for on-shoring limited at best. The amount of money that has left the US after Biden’s election victory will not allow for expansion of the US economy as promised by the campaign. Asia and Europe are the winners for economic expansion.
EU Honeymoon short lived
As the US struggles well into 2021 to restart the economy, tensions will grow with the European Union (behind the scenes) as the Biden administration has been put into a political corner over Russian actions globally. Nordstream II will be a very contentious point between the US and Germans, something that will be exacerbated with the German elections in August. Further cracks will appear between the US and EU over next two years over foreign policy issues in North Africa and Indo-Pacific, as the Europeans balance their need for China’s market and limiting Beijing’s push into Emerging Markets. It is likely the US will get drawn into proxy conflicts in the Horn of Africa and possibly the Middle East.
The real choice in European and especially German politics is whether to support eurozone integration
Superficially, 2020 was a good year for eurozone integration because the EU agreed a recovery fund. However, I remain of the view that it was more Calonne than Hamilton. Its size is of a magnitude between what the EU spends on defence and what it promised to spend, around 0.7% of GDP. It is more than nothing, but less than something. Even if the fund becomes a permanent fixture, it would not be what many had in mind, who had long advocated for a eurobond. At the end of the day, this is still an inter-temporal, inter-governmental transfer. It is not EU money funded by an EU tax. This has to happen for the eurozone ever to get a joint fiscal facility, a proper eurobond. The recovery fund is not it. Nor is the EU budget the mechanism to deliver it.
The recovery fund is, however, very symptomatic of Angela Merkel’s approach to European integration. She is a pro-European inter-governmentalist. As such, it should come as no surprise that she delivered an inter-governmental fund, but managed by the European Commission. She prioritises cohesion over integration, and regards the European Council as the institution to guarantee the former. This first became apparent in 2008, when she rejected a eurozone solution to the banking crisis. She later rejected eurobonds as an instrument to stabilise the eurozone during the sovereign debt crisis. She supported austerity and the German debt brake, which took effect under her leadership. And she brought a recovery fund financed inter-governmentally.
The result is a eurozone that is more divergent today than it was 15 years ago. The EU has also become more tolerant of undemocractic regimes. Merkel’s EPP kept the membership of Viktor Orbán’s Fidesz. To break the recent gridlock over the EU budget, Merkel resorted to a most foul compromise. She rendered the rule-of-law mechanism essentially inoperable. If the EU had chosen to de-link the rule-of-law mechanism from the EU budget, and taken the recovery fund into enhanced co-operation, that could have been the beginning of a future fiscal instrument. It was therefore no surprise that Merkel fought hard to prevent this. It would have been the opposite of everything she stands for.
The question now, as Merkel enters her last year in office, is whether her successor will stay on the same side of the cohesion-versus-integration nexus. Unfortunately, it serves no purpose to figure out whether German politicians are pro- or anti-European. The real dividing line in the EU is actually between pro-Europeans like Merkel who favour cohesion over integration, and pro-Europeans like Emmanuel Macron who favour the opposite.
There are no true eurosceptics in German politics, except in the AfD. Nonetheless, there are very few politicians who would position themselves at the Macron end of the cohesion vs integration axis. Friedrich Merz is a fiscal conservative and an ordo-liberal. Armin Laschet is pro-European in sentiment, but of the old-school corporatist variety. Norbert Röttgen is an interesting candidate for the CDU leadership because he is definitely more pro-integration, yet his focus has been mostly on foreign policy. Markus Söder, the CSU chairman, is hardest to read.
The history of the EU suggests that integration happens if the leaders of France and Germany push in the same direction. The Franco-German axis is not the same as it used to be, but it is still the most formidable political force in the EU today. The fate of eurozone integration will thus depend on the outcome of the German elections in September 2021 and the French elections in April 2022. From the perspective of the eurozone, it is best to consider the two elections together.
To prosper, the eurozone will require a different governance framework than the current one: a system of archaic fiscal rules combined with ad-hoc crisis management. The pandemic has raised the eurozone’s debt-to-GDP ratio by some 20pp, and this ratio will no doubt rise further in 2021. The ECB will need a new mandate to be able to absorb some of this debt, rather than go deeper into a legal grey zone. More importantly, it will require a fiscal counter-part as we enter a world in which the classic trade-offs between fiscal and monetary policy are breaking down.
The real choice in European and especially German politics is:
· whether to support eurozone integration, or
· whether to prioritise keeping Hungary and Poland on board, or
· whether to prioritise a trade surplus with the rest of the eurozone and the world.
These are all mainstreams strands in German politics. Don’t be fooled. They all fall under the umbrella of what people call pro-European. That term is a most useless category.
What’s in store for Emmanuel Macron in 2021
What will the new year bring for France? Brexit traffic chaos for sure. What else? More lockdowns, protests, bankruptcies and debts? With the pandemic, Emmanuel Macron’s image turned from being the reformer of last resort to the protector of last resort. His pledge for 2022 elections will be a balancing act between maintaining authority and being with the people. France’s role in Europe will also be tested next year before taking over the EU presidency in spring 2022, just before the French presidential elections.
The pandemic will still take precedence in the first quarter of next year. Vaccination have just started. To reach herd immunity, it will take months to roll out the whole programme and to convince the French to take the jab. France is among the most vaccine sceptical of all European countries. Only 54% said they would get the jab once available. Herd immunity threshold for coronavirus varies according to the disease, but experts suggest something between 60% and 70% of a population is needed for Covid. This means more needs to be done to convince the French to get vaccinated.
Emmanuel Macron warned about a confidence crisis against authorities, including scientists, this week. His government has its own battles to fight over the security and separatism bill which will enter the senate and the assembly in January. The ban on sharing information about the police in action is at the centre of a public controversy that already mobilised protesters to go back to the streets despite the lockdown. The government promised a rewrite, but more clarity is also needed to fight wilful misinterpretation and to explain better. Macron even used the quarantine after testing positive to make the rounds in the media. This is just the beginning of a long communication marathon.
The emergence of new strains of Covid also infers a third lockdown is on the horizon. This would put further pressure on those sectors forced to suspend their activities and on public funds. The promise of whatever it takes cannot be rolled over forever, and companies cannot stay on an artificial life line forever. The state is already reducing its offerings and increasing pressure on banks and insurers to give hard-hit sectors better conditions to survive.
Once the health emergency eases up, the debate about public debt will re-emerge. The French finance ministry expects a rate close to 120% of GDP by the end of this year. What lessons will be drawn from this by the French and fellow Europeans? A 40 percentage point difference with Germany surely does not bode well for future discussions on fiscal policy and recovery funds in Europe.
Another issue is border control. Will France pursue its ambition to reform Schengen to better protect Europe? This has been on the French agenda since Nicolas Sarkozy, but never progressed far enough in the discussions with other Europeans. The pandemic, with its chaotic and unilateral shuttering of external borders during the first lockdown, could make a case for a rethink. The Commission is to prepare the grounds next year. Will Macron push this to the finishing line once France takes over the EU presidency? The French idea at the moment is to establish something like the eurogroup for Schengen to allow political coordination in crisis times like these. Also data sharing, while technically possible, is not happening as it should, due to mistrust between different authorities. This project will need much more attention if it is to take off.
The other forceful role France carved out for itself is on European foreign policy, in particular its strong opposition against Turkey. However, despite Macron’s strong rhetoric, its formal complaint logged with Nato and military exercises with Greece in the eastern Mediterranean, EU leaders could not agree on tough sanctions and pushed forward to the next council any biting decision. However, in actual fact, Macron himself weakened his position ahead of the European Council meeting in early December by receiving Egyptian president Abdel Fattah Al-Sisi, and even granting him France’s highest award, the Légion d’honneur.
And then Brexit. France has played an active role during the negotiations over fish. France also went further than others by imposing a travel ban, not only on flights and trains, but also on freight between the UK and the continent. They re-opened the border to those who can produce a PCR test not older than 72 hours. Surely, introducing a Napoleonic Continental System in times of crisis, based on dubious rationale, is more a sign of Burkean nationalist tendencies, rather than co-operative globalist ones.
As such, how France will take its role in the EU forward will depend on whether they come up with concrete enough proposals and whether they can build alliances and trust amongst other European leaders. Past failures should not limit what can be achieved next year. After 2020, we need a different narrative for Europe, and France could do its bit in helping to draft it., but is Macron the leader for such?
A Brexit deal frees the UK of Brussels control – what is the future
The UK has a truce with Europe. It does not yet have a settlement. Brexiteers have secured the essential possibilities that they sought. Perfidious Albion emerges from the negotiating ordeal battered and chastened, but nevertheless a self-governing sovereign democracy in the remaking, if it can rebuild its institutions after 40 years of hollowing out and creeping political infantilism. It has evicted the European Court, which expanded the EU rights charter into an all-purpose text for jurisdiction over anything it wanted and swatted aside the UK’s Common Law protections in the protocols of the Lisbon Treaty. The “direct effect” of EU law invented by euro-judges in the 1960s with breathtaking boldness, and with no treaty justification, is finally over.Lex est anima totius corporis popularis: law is the collective mind of the people. It is elemental. The British have retrieved it. They can once again sack their upper executive when it commits grave errors. They are no longer subject to a permanent regime, an unchanging cartel of incumbents, a latter day Congress of Vienna. They no longer have an upper civil service in Brussels with sweeping powers of legislative initiative, acting as an ideological Praetorian Guard. These are big constitutional changes.
However, it is naive to think that this Brexit deal can ever be a stable equilibrium. The language invites continuous wrangling. That is not a criticism of Lord Frost or Downing Street. They managed to draw bucketfuls of poison from the text. They held Brussels to a tactical draw, even if it is not quite the Agincourt that some wish to believe. The intricate sub-clauses of the UK-EU Trade and Cooperation Agreement give Brussels countless ways to try to keep Britain within its legal and regulatory orbit, and it will undoubtedly try to use them. The Swiss have been living through such harassment for a long time. The pressure never stops. The difference is that Britain is eight times larger than Switzerland; it is a nuclear-armed military power; and it is not trying to cling onto the edges of the single market.
Whether this deal ultimately blows up depends on how far Brussels tries to exploit the levers of remote control written into the text. That is a question of statecraft. Will the EU opt for a permanently hostile relationship with Britain or will it recognise that this is never going to work, even under a future Labour government, and opt instead for a strategic alliance on the basis of sovereign equals? There is certainly going to be trouble, because Britain must legally change its regulatory system in order to join the Asian trade bloc (TPP). This will become the biggest free trade zone by far once the United States accedes under Joe Biden, ultimately leaving the EU as the much smaller economic area, and also as the world’s slow-growth backwater if it is not careful. The moment that the UK starts to make these changes, Brussels will scream divergence, or make accusations of “unfair competition”. It is a clash of two incompatible philosophies on what constitutes free trade and what drives the process of economic development and wealth creation. But this battle must be had.
So-called “lightning” sanctions have been struck out of the text but the principle of “cross-retaliation” remains. The ratchet clause has gone but has been replaced by a “rebalancing mechanism” with plenty of hooks. It is unlike anything else that exists in international trade law. Brussels will have to prove its point before an independent panel before it can retaliate. Divergence must be “material” and based on evidence of damage suffered rather than “mere conjecture”. Sanctions must be proportional. “The mechanism is exceptionally restricted in its scope,” according to Prof David Collins, a WTO specialist in an article for Politeia. The thresholds are high enough that the EU cannot lash out whenever Britain takes any step to make itself more competitive. That is to say, the EU will have some trouble using anti-Ricardian practices, the Acquis, to lock in its structural trade surplus with the UK in perpetuity.
Their ultimate pressure tools are the inelegant “Art.Comprov 12” and “Art.INST. 35” that allow either party to shut down the accord if they think there has been a “serious and substantial” failure over environmental policy, the rule of law, democracy, and so forth. “We’ll always have the Sword of Damocles hanging over us,” according to Professor Jonathan Portes from King’s College, London. “There will always be a constant threat.” There are a lot of things that the EU has not agreed to. The EU is being horrible about professional qualifications. It has denied the UK mutual recognition for conformity assessment on products – the bare bones courtesy extended to Canada and Australia. It has refused to reciprocate financial equivalence, already a minimalist arrangement that can be yanked away on 30 days’ notice. It is withholding cooperation that it offers New York or Singapore in areas such as derivatives, whether in order to trickle out rewards for “good conduct”, or to squeeze as much business as possible out of the City and into its own financial centres. These are aggressive gestures. The EU is not acting as a friendly power.
Personally, I would support this deal out of realpolitik. Some irritating wrinkles may be sorted out over time. One could argue that the exact terms are a work in progress. It shoots Nicola Sturgeon’s fox and may lower the temperature of the five-year independence civil war. It avoids collateral harm to Ireland. It helps smooth the way for cordial ties with Joe Biden. It avoids a rupture that would have been misunderstood by much of world opinion. Macchiaveli might have fretted over the booby traps. Guicciardini would have retorted more urbanely that human affairs are in constant flux. Future problems often fall away over time.
The EU is itself in permanent crisis, seething with anthropological contradictions, likely to lurch from one drama to another, and condemned to a monetary union that can never be made to work but cannot be broken either without immense trauma. Yes, the EU gets much of what it wants out of this deal. It has saved its full access to the UK market for goods and saved much of its £95bn bilateral surplus, but has stiffed the UK royally on services. This profound asymmetry should never have been conceded at the outset of the Brexit process. The EU is itself in permanent crisis, seething with anthropological contradictions, likely to lurch from one drama to another, and condemned to a monetary union that can never be made to work but cannot be broken either without immense trauma. Yes, the EU gets much of what it wants out of this deal. It has saved its full access to the UK market for goods and saved much of its £95bn bilateral surplus, but has stiffed us royally on services. This profound asymmetry should never have been conceded at the outset of the Brexit process.
The imperative now is to join the TPP and to secure a deep free trade deal with the US as fast as possible. This would confront Brussels with a choice: either ease up on certification, services, and equivalence; or accelerate the UK’s switch into a different regulatory ecosystem irreversibly, and perhaps risk being half-marginalised in global finance by an Anglo-American axis, NyLon reborn. Britain must never again find itself in a position where the EU controls so many chokeholds. It must break reliance on Dover and spread food purchases far and wide, as competitive logic dictates in any case. Brussels threatened to cut off Britain’s electricity interconnectors at the height of winter if it did not come to heel. Once played, that card cannot be unplayed. The interconnectors are no longer politically safe. This country must push faster for energy self-sufficiency, bringing forward electrolysis to convert North Sea wind power into hydrogen and synthetic fuels for global export. It must restructure industrial supply lines rapidly, almost if reorganising the economy for wartime mobilisation. Only then does the “rebalancing mechanism” lose its menace. Only then do we take the sting out of “cross retaliation”. Only then can we have a stable relationship with Europe.
What to expect for the UK economy this year
So, sticking with the Brexit theme first, a thin deal is clearly better than no-deal. Alongside that, Liz Truss, the international trade secretary, has got on in rolling over those EU deals. The Brexit deal will still damage the economy in the medium and long term, but avoiding most of the short-term chaos of no-deal and a schism in Britain’s trade relations with other countries is better than the alternative.
Second, while Covid-19 still stalks the earth, this will be a good year for the global economy, and when it does well, the UK should not be too far behind, given its historical positive correlation with global growth. Now, the global economy shrank by 4%-4.5% in 2020 and leading forecasters expect it to grow by 4%-5% this year, led by China. We should put that in perspective: 2020 saw the biggest downturn in the global economy in living memory. The 2009 recession saw global GDP drop by 1.7%, on World Bank figures, and that was followed by a brisk 4.3% recovery in 2010, although it did not necessarily feel like it. But a global rebound is better than stagnation, or worse.
Third, a couple of UK-specific factors. There have been two striking things about the economic numbers in 2020. The first is the build-up of involuntary savings as restrictions limited people’s spending. The saving ratio — saving as a proportion of disposable income — rose to a record 27.4% in the second quarter and stayed at a high 16.9% in the third, even as the economy recovered. What this means, the Resolution Foundation think tank believes, is that “social spending” — travel, hospitality, entertainment, physical retailing and so on — will bounce back “very quickly indeed … once a semblance of normality returns”.
A related development, also a reason for optimism, is that the peak in unemployment will be lower than feared. Government measures, including the extension of the furlough scheme until the end of April, should mean the jobless total tops out at well below three million, or 7% of the workforce — lower than after previous, milder recessions.
Then, fourth, vaccines. The very good news last week was regulatory approval for the Oxford/Astra Zeneca jab. That offers the very real prospect of a sustainable way out of this crisis. While everybody is focusing on spring, this should at least guarantee that the second half of the year is better than the first.
On the flip side, and there is always a flip side of course, one issue is the coronavirus, whose new variant is more transmissible. Certainly, viruses do mutate, and as such, they typically become more contagious, but less deadly. Yet, we do not know how many more surprises it will throw, or more to the point, how high the incompetence of the government in its handling and persistence in locking down the economy.
In addition, another potential negative is how the Treasury deals with the fiscal hangover of the crisis. With a budget date set for March 3, quite a few people have got in touch to ask whether there will be tax increases then. I have said not, although the chancellor might provide signposts, but we shall see. We will also see whether the current unusual combination of record deficits and very low borrowing costs can last, and whether the Bank of England will do more quantitative easing (QE) and/or negative interest rates, although in my opinion, the latter is most unlikely, as to date Anglo-Saxon central banks have been mot averse thereto.
Adding all this up, what kind of growth can we expect for 2021? The Office for Budget Responsibility, in its late November forecast, had a central forecast of 5.5% growth this year, after last year’s 11%-plus decline. The Resolution Foundationsuggests that first-quarter restrictions will knock that down to about 4.3%, which seems reasonable.
A wave of corporate insolvencies is coming to the EU
One of the big fears about the economic impact of Covid which has yet to materialise so far is a corporate solvency crisis. Of course, this will happen eventually, perhaps starting in the coming year. The problem was identified relatively early, but the initial policy response to the pandemic focused on liquidity and credit provision, not on solvency. The assumption that companies remained fundamentally solvent, but needed liquidity support to make it through a temporary reduction in revenue, depended crucially on the health emergency being short-lived. Unfortunately, the initial roll-out of vaccines will take at least six months, and that’s mostly limited to the North Atlantic region. So, the pandemic will have lasted eighteen months to two years in the best of cases. This means solvency issues cannot be ignored. The problem is that, even at this relatively late stage, not enough is being done to support solvency, especially of small firms.
Evidence that liquidity is being used to sweep solvency problems under the carpet, rather than solve them, comes from insolvency statistics. In many jurisdictions, insolvency rates have actually dropped during the pandemic so far. This makes it likely that many companies that would have gone bankrupt under normal circumstances are in fact not going bankrupt due to various aspects of the crisis response, despite the loss of revenue reflected in the substantial fall of GDP. This leads to justified fears about the creation of zombie firms, and about a wave of insolvencies when support measures are actually withdrawn with a possible cliff effect.
To put things into perspective, and to bring them home to the eurozone, one of the best sources remains a European Commission staff working document released alongside the initial proposal for a recovery fund in late May. It identified three investment needs to get out of the crisis, the first of which was equity repair. Back then, based on the severe scenario from the Commission’s spring forecast that has already been exceeded by events, the working paper estimated a damage to corporate equity of at least €1.2tn EU-wide. A lot of this would be made up by liquidity support and companies eating into their cash buffers, but in the end the Commission staff expected an investment shortfall to result, of more than €800bn euros in the private sector alone in 2020 and 2021. Given how the pandemic is playing out, these figures must be taken as an under-estimate of the actual impact.
And yet, solvency support is still sorely lacking. The EU’s much-touted recovery plan consists of €310bn in grants, allocated over 3 years and spent over 6 years. This compares very unfavourably with an expected investment shortfall of at least €800bn over just two years. In addition, the EU’s timid attempt to set aside just €31bn for a solvency support instrument was one of the first components of the original recovery plan to be discarded in negotiations within the European Council.
So, what is to be done? The Group of 30 recently put out a policy analysis of the corporate solvency problem. Their advice to policymakers is, first, to focus on:
· the long-term health of the corporate sector by: acting urgently, with targeted support, and adapting to the post-pandemic world rather than preserving the status quo;
· productive use of resources by: addressing market failures such as SME access to finance or the effect of high uncertainty on investment, tapping private-sector expertise, and balancing national objectives with business support needs; and
· avoiding collateral damage by: limiting the risk to public finances and the potential for unjustified windfalls to the private sector, trying to get the timing right, and anticipating potential spillovers to the financial sector
Basically, there are two principal risks. First, that policymakers may fall into complacency because of the cushion provided by the recovery fund. Secondly, unwillingness to make the unavoidably political choices involved in putting together a sensible solvency support package will lead to policy paralysis.
What’s in store for the ECB in 2021?
For the ECB, 2020 was supposed to be a year of calm transition. Mario Draghi’s last policy package had hopefully loosened policy enough to deal with a budding recession, and Christine Lagarde expected to focus her first year as ECB president on the policy review. However, the pandemic intruded. 2021 could be similar.
At its December monetary policy meeting, the ECB governing council expanded its emergency response and extended it in time to at least next September, with some measures already billed to last until the following June. The ECB is allowing itself to buy another trillion euro worth of assets, mostly government bonds, with full flexibility to stabilise markets. Liquidity support for banks has been assured with pandemic long-term refinancing operations, and the TLTRO 3, the ECB’s funding-for-lending programme, will continue to offer additional liquidity to banks until the end of 2021 and an interest rate of -1%, 50 basis points below the deposit rate, at least until June 2022. Covid-19 vaccines will be rolled out over the first half of next year, although the EU is likely to suffer inadequate supplies due to a poor procurement process.
The most important item on the ECB’s calendar in 2021 will be the policy review, which will likely bring a change in the inflation target. The results are expected at the end of June next year. The ECB could spend the second half of the year adjusting its policy for 2022 in light of the evolution of the pandemic. With any luck, at the end of the year they could declare the pandemic emergency over and return to still expansionary but not exceptional policies. Perhaps a TLTRO 4 to avoid a bank liquidity cliff edge, stopping pandemic asset purchases but continuing QE at moderate levels, and so on. What could possibly go wrong?!!!
As 2020 has shown, lots of things could go wrong. Brexit actually happening, for real this time, could turn out to have a more negative economic impact than foreseen, especially in the initial months. Or the EU does suffer inadequate supplies of vaccine, which prolongs business restrictions. Or the dollar could depreciate substantially relative to the euro. The solvency crisis could happen, and trigger a banking crisis. What about the return of a sovereign debt crisis, as the EU sovereign-bank nexus has deepened this year, according to S&P Global.
It is possible that the supervisory board of the ECB will have more work next year than the governing council. Evidence is that the pandemic is already leading to a deterioration of banks’ balance sheets. On the asset side, Covid-19 is already contributing a couple of percentage points to non-performing loan ratios in some countries. Loans that are still performing but have suffered a loss of credit quality, called Stage 2 under the new IFRS 9 accounting standards, have increased markedly, including in some core eurozone countries. The banks that were already lagging behind in their build-up of bail-in-able liabilities are now actually slipping back on their targets.
The potential for a banking scare in one or more countries, not all of them the usual suspects, is high. And the more vulnerable banks may not be in a good position to execute their resolution plans. The eurogroup agreed for the ECM backstop to the resolution fund to begin operating by the start of 2022. Let’s hope it is not needed before that.
The EU between the US and China
China’s rising influence was one of the biggest stories of 2020. China surpassed the US to become the EU’s top trading partner this year but, as the EU’s economic relationship with China has deepened, so too have security and human-rights concerns. Rising Sino-American tensions have simultaneously left Europe caught in the middle of a new cold war. A late-year push to finalise the long-awaited EU-China comprehensive agreement on investment looks increasingly incompatible with efforts to reset the transatlantic relationship. The EU doesn’t want to pick a side, but in 2021 it might have to.
Europe once welcomed Chinese investment, particularly in the wake of the global financial crisis and the eurozone crisis. However, concerns about China’s divide-and-conquer strategy have been rising since China’s launch of the 16+1, now 17+1, format in 2012, since subsumed within the Belt-and-Road Initiative. However, it wasn’t until the Covid-19 pandemic hit that the EU began to see China less as a valued investor, and more as a worrying rival. Highly-publicised Chinese donations of medical equipment deepened north-south EU divisions at the onset of the pandemic, and a gradual shift towards more aggressive wolf-warrior diplomacy enraged some member states.
Tensions boiled over during the late-summer European tour of Wang Yi, the Chinese foreign minister, with EU leaders scolding China for its human rights record and for making threats against some member states. A subsequent EU-China videoconference summit held in mid-September ended with the EU calling on China to offer reciprocal market access. It appeared to be the final nail in the coffin for the EU-China investment agreement.
Wang’s visit was one of the few times the EU presented a united front. Divisions between member states have been particularly visible in 5G development. Only Sweden and the UK have definitively excluded Huawei from future 5G development. Huawei has already been instrumental in building many 4G networks in Europe. Decoupling from the company will be costly and time-consuming, and raises questions about whether European companies are capable of replacing it. Nokia, for example, still cannot manufacture its own 5G chipsets, and plans to sink most of its profits into R&D next year as it scrambles to catch up.
Replacing Huawei equipment is expected to cost billions in the US, which has taken a much stronger stance against China in recent years. The US position has undoubtedly impacted EU 5G development strategies, and American officials have repeatedly and aggressively lobbied European allies to drop Huawei from 5G development.
Sino-American relations deteriorated rapidly under President Donald Trump. So did transatlantic relations. We expect EU-US ties will continue to face challenges in 2021, particularly given the surprise announcement earlier this month that the EU is hoping to ratify the investment agreement with China by the end of the year.
The European Parliament was outraged. Will no one think of the Uighurs? But, as Angela Merkel made clear last week, forced labour in Xinjiang is a secondary concern.
The EP has vowed to block the investment agreement. A bigger concern for the European Commission might be that the US may try do the same. Views differ, but most observers agree that president-elect Joe Biden will maintain a tough line on China. This certainly appeared to be the case yesterday when Jake Sullivan, Biden’s incoming national security advisor, gently scolded the EU over the investment agreement. Sullivan tweeted that the Biden-Harris administration would welcome early consultations with European partners on common concerns about China’s economic practices.
So, while the agreement might be billed as a victory for Angela Merkel as she exits the political stage, it will also pose a major challenge to any potential transatlantic reset.
Some in Europe have objected to the notion that the EU should have to call the US before signing an investment agreement. Strategic autonomy is a priority for Ursula von der Leyen’s geopolitical Commission, and an agreement with China should not require US approval. Others argue that the agreement has already stirred up trouble between the EP and the Commission, and that China has succeeded in driving a wedge between the EU and US before Biden even takes office. This means that, even if the deal is not ratified, it’s still a win for China.
This all raises the question: what does strategic autonomy really mean? The freedom to trade, the freedom to take a principled stance, or the freedom to avoid choosing sides? Josep Borrell, the EU’s high representative, says it means not being dependent on other countries. If this is true, then the EU will not make much progress on strategic autonomy next year. Germany’s large trade surplus with China has been the single largest obstacle for EU efforts to adopt a tougher stance on China. This might continue to be the case, depending on the outcome of next year’s elections in Germany. Lacking its own tech giants and dependent on trade surpluses, the EU is at high risk of remaining hamstrung by its mercantilist foreign policy in 2021.
And now to cover a potential political crisis within the EU…
The politicisation by Brussels of Covid vaccines could well turn into an economic and political black swan event – with a huge price to pay
The EU’s politicisation of Covid vaccines is turning into an economic and political black swan event. There will be a price to pay as the consequences of this profound failure unfold in 2021, and an even higher price as people start to understand why it happened. Europe’s double-dip recession will be stretched out for another quarter. Recovery will be delayed until the second half of the year. Thousands more companies will be pushed over the brink, threatening a cascade of defaults and raising the risk of systemic solvency across the banking nexus. Labour scarring will run deeper. Public debt ratios across the Club Med bloc will move closer to the point of no return.
As already discussed above and previously, it is by now widely known that the European Medicines Agency wasted two critical weeks after the UK, Canada and even America’s notoriously cautious FDA had approved the Pfizer BioNTech vaccine. The agency would have wasted another week had there not been furious complaints from Berlin. The Commission’s insistence that all EU states should then launch the vaccine at the same time after Christmas has lost yet more critical days. Germans have been subjected to the surreal spectacle of trial drills by their well-organised vaccination machine when they could have been doing the real thing. They have only just started to receive a jab made by their own start-up group BioNTech. “Germany has bet on Europe, and lost heavily (krachend verloren),” was the headline across Die Zeit, with a pointed picture of a woman in Cardiff being vaccinated while along with a caption declaring that Germans must wait such deliverance. The Netherlands has compounded the error by so mishandling its software preparations that it will not start vaccinating until Jan 8. If you think Boris Johnson has had a bad pandemic, take a look at Dutch wunderkind Mark Rutte. Listen to the volcanic exchanges in theTweede Kamer.
However, these delays pale compared to what is coming next year. The European vaccine alliance has failed in its one overriding purpose: it neglected the job of acquiring vaccines. Germany has just 400,000 doses of the BioNTech jab and may not receive more than 3m or 4m by late January, rising to a total of 11m to 13m by the end of March. Berlin has taken matters into its own hands and belatedly ordered more for the future but the damage is done.
The devastating report by investigative journalists at Der Spiegel entitled “The Planning Disaster” pulls away the curtain on the ineptitude of the European Commission, which drifted through the summer with much self-gratulation but little action. Other countries ordered early, and ordered wide. Brussels picked a mix of vaccines that mostly will not be ready until the second half of 2021 at the earliest. It failed to lock in a firm order for the BioNTech jab until mid-November, long after it was already clear that this messenger RNA vaccine was a front-runner. Even then it declined the full offer of 500m doses for the EU27. The Commission ordered just 200m, with an option for 100m more. It also turned down most of the offer from Moderna, the other mRNA front-runner. According to Der Spiegel there had to be parity with Sanofi’s “French vaccine”, which has since gone badly awry and is unlikely to come on stream before the end of 2021. “Buying more from a German company wasn’t in the cards,” said one source.
You can interpret this as a case of European ideology and political correctness running amok, but there is an even worse construction: the Commission seems to have intervened in the interests of one commercial company, spending public funds corruptly in violation of its own competition law. According to Der Spiegel article:
The combination of a delay of vaccine approval and a procurement policy under suspicion of prioritising producer interest would be a shock from which the EU would struggle to recover. From now onwards, Covid deaths may be EU deaths.
In my view we are heading into a year where German popular support for the European Project will be stresstested like never before. Two grave matters will intersect. It will become clear to all that the fundamental health security of the country has been endangered by EU politics. At the same time, monetary union will go through another spasm of tension. Europe’s leaders have oversold the €750bn recovery fund as a springboard for Keynesian reflation. It is spread too thinly over five years to move the macroeconomic needle. Almost half of the money is in the form of loans that may never be used – except in extremis – because of the Troika-like conditions attached. Budget plans in southern Europe suggest that much of the grant component displaces money that would have been spent anyway and therefore adds no net fiscal stimulus. Yet a third wave of Covid and further rolling lockdowns, now unavoidable, means that the overall fiscal package will have to be greater. There is already talk sotto voce that the recovery fund will need to be much larger to avert lasting economic damage. If so, it means telling German and northern European taxpayers that they will have to dig deeper into their pockets to fund even greater transfers to the South.
The European Central Bank can shut down the price signals in the sovereign debt markets for a while longer by soaking up the bond issuance of Italy, Spain, Portugal, and indeed France, but the longer it does so, the clearer it is that the ECB is conducting fiscal policy and propping up insolvent sovereign states in breach of EU treaty law. While the latest programme of pandemic QE lasts in principle until March 2022, the problems will surface before then. German public opinion and part of the economics professoriate will react once there are first flickers of inflation, which will occur around Easter for mechanical “base-effect” reasons and because of commodity supply constraints. You can dress up QE as an emergency tool for fighting deflation. How do you explain it if prices are rising briskly?
For now attention is on Britain’s particular travails but this is unlikely to last. Scientists working in the UK discovered and tracked the B.1.1.7 mutation because this country has done almost as much genome sequencing of Covid-19 as the rest of the world combined. As Nervtag said in its report, this mutation was particularly hard to sequence. Covid-19 Genomics UK Consortium (COG-UK) makes these sequences available to international science, a big contribution to the global fight against the pandemic that is little appreciated in lay circles. You certainly would not know this from some of the abuse being hurled at Britain. Italy’s health adviser Walter Ricciardi descended to inexcusable depths in an interview with Il Messaggero in suggesting that the UK knew about the virus in September (it did not: the sample was collected in September, one of thousands of mutations) and has since engaged in a Wuhanesque cover-up. It is possible that the mutation came from Italy in the first place for all we know. It might have come from the treatment of an immuno-compromised patient in the UK treated with neutralising antibodies, but we can’t be sure. It is too early to reach any conclusion. The larger point is that the UK acts as Europe’s viral antennae. There has been more Covid sequencing from Wales than from the whole of France. Once EU states carry out full surveillance of the mutant strain they may discover that it has long been circulating on the Continent, explaining the parabolic surges that have caught so many governments off guard over recent weeks.
The great irony is that only the Oxford-AstraZeneca vaccine will be available soon enough and at a larger enough scale to prevent a disaster for Europe over the next six months. The mutation makes it even more urgent. “Right now, whether Germany fares well or not hinges on the AstraZeneca vaccine,” so said Karl Lauterbach, health chief for the German Social Democrats. The vaccine will almost certainly be approved in the UK the week after Christmas. The European Medicines Agency will have to decide whether to swallow its pride and accept an accursed product of this apostate island. My guess is that it will drag feet for faux procedural reasons until public opinion and the German Chancellor force the issue.
Whatever happens, it is going to be a very difficult time for Europe. People will notice as the UK conducts several million vaccinations a week all through January in a massive operation that draws on the best of the NHS and the British armed forces. There will be the same images in America, Canada, and elsewhere. They will ask why the doses are being dribbled out so desperately slowly across the Continent, and when that happens Brussels will struggle to offer a credible answer. If EU elites don’t yet realise that this is going to mushroom into one of the biggest failures in the history of the European Project, they will find out soon enough. Just consider the data below to start with.
Manias often end around the turn of the calendar year
This makes sense to me because many behaviors change as incentives change when the calendar turns. Flows that needed to be done by year-end (such as benchmark adjustments, rebalancing, etc.) often dry up as the year turns and new flows begin. Also, importantly, most hedge funds mark to market on January 1 so gains and losses from the prior year become irrelevant and incentives and behavior change. A 5% correction feels different in January than it did in October.
Anyway, we had a little look at the biggest bubbles of all time and found the date of the high for each one. Here is the result:
Here are the bubbles I looked at and the dates they peaked:
So the takeaway is that 42% or 57% of bubbles (depending on your look back) peaked around the turn of the year. Given I broke the year into six two-month buckets, evenly distributed data would show something closer to 17%. The sample is small, so this could all just be random, but I doubt it. I think the mark-to-market argument is especially relevant as formerly strong hands become weak after they mark to market at the ding dong highs on January 1. Therefore, I doubt this result is an artifact of randomness. In case you are a math person, arc sine law does not apply here because we are not looking at yearly highs or lows, we are looking at highs over a long sample with an arbitrary start and end point.
Some food for thought then…
Fiscal policy may become sufficiently stimulative to reverse the direction of travel for equilibrium real interest rates.
When Lawrence Summers identified the central importance of secular stagnation for the global economy in his speech at the IMF in 2013, the Harvard professor put his finger on the most important motivating force for the financial markets in the 2010s. And it remains so. The direction of secular stagnation after the pandemic passes into history will be crucial for asset prices. Prof Summers’ interpretation of the term, originally coined by Alvin Hansen in 1938, argued that excess savings relative to intended investment had driven the global equilibrium real rate of interest well below zero by the mid-2000s, making it difficult for monetary policy to provide the needed stimulus after the 2008 financial crisis. Actual real interest rates did fall somewhat, but not enough to forestall sluggish growth, so inflation dropped below the 2 per cent central bank targets, notably in Japan and the eurozone.
These forces explained many of the key trends in global markets. Short-term interest rates remained “lower for longer”, not because the central banks tried to inflate an artificial bubble in asset prices but because they responded appropriately to the downward pressure on equilibrium real rates. Nominal and real bond yields continued to fall in advanced economies, hitting the effective lower bounds in many. As the demand for “safe” fixed income securities exceeded supply, a desperate search for yieldspilled into corporate credit and emerging market debt, forcing credit spreads lower.
Equities benefited from the lower discount rate on future profits resulting from lower risk-free interest rates. Share prices defied the sluggish growth in output and rose to dizzying heights. Meanwhile, profits have benefited from low wage inflation, another possible symptom of secular stagnation. Yale’s Robert Shiller, who had warned of earlier equity and housing bubbles, has recently written that lower bond yields support the high valuations of equities, relative to past and future profits. In his view, there is no obvious equity bubble in the overall market this time. Equities that gained from technological and structural changes, in particular, the Faangs — Facebook, Apple, Amazon and Google and Netflix — were deemed to have the best long-term revenue growth prospects, so they benefited the most from declining discount rates. However, recent valuations in these new growth companies, fuelled by speculative phenomena such as the explosion of special purpose acquisition companies, or Spacs, do seem to be extremely frothy and are very vulnerable to any rise in real bond yields.
Even during the pandemic, secular stagnation still played a critical role. Markets had become accustomed to large-scale central bank asset purchases alongside burgeoning US budget deficits under President Donald Trump, without seeing any adverse effects. So they were willing to accept the massive fiscal and monetary injections of 2020 with equanimity. A few decades ago, when global savings were in short supply, that would not have been the case. A global pandemic during the inflationary 1970s would have raised interest rates, making expansionary policy far more difficult.
It is little exaggeration to say that investors are all secular stagnationists now. But what of the future? The latest thinking from Prof Summers, Jason Furman and other academic proponents of the theory suggests that the same long-term forces that have dominated recent decades will re-emerge after the pandemic. They reject the idea that structural forces such as the global savings glut, demographic ageing and income inequality will reverse sufficiently to end this saga in the next few years. Nor do they expect a “Roaring 1920s” spending mentality to emerge after Covid-19. This is in line with a recent lecture by Helene Rey. She argues that the long-term effects from the financial crisis and the pandemic will keep equilibrium interest rates very low during the 2020s.
Financial markets are likely to resume the behaviour seen before the pandemic. Near-zero bond yields will support buoyant equity markets. However, there is a caveat: fiscal policy may become sufficiently stimulative to reverse the direction of travel for equilibrium real interest rates. As US president-elect Joe Biden enters office, secular stagnationists are putting pressure on himto seize a rare opportunity to reject austerity and boost the fiscal stimulus by $2.5tn from 2021-23. Other commentators have argued that the legacy of high public debt ratios, taken alone, should not result in financial crises or inflation, so in theory there is plenty of fiscal scope for expansion. An economic Marshall Plan is clearly needed to repair infrastructure, improve climate change and reduce inequality.
But what is good for the world economy is not necessarily good for asset prices. A fiscal injection of several percentage points of US gross domestic product could begin to reverse secular stagnation. But it may also raise long-term discount rates and puncture the bull market in global equities. Investors should be careful what they wish for.