Take a little quiz with me, will you? Here is a chart of current account deficits, courtesy of the IMF. The purple line is the European Union; the dark red, with the biggest spike, is EM and developing economies. The EU has been steadily improving; EM countries have deteriorated but are still in surplus. Which country is represented by the blood red line at the bottom of the chart?
Here’s a clue that might help you. The political activity in this country in 2017 has been captured on Twitter by the Southern African correspondent of the FT, Joseph Cotterill. Here’s a flavour of what he covered last year:
This journalist is used to covering politically unstable regimes. Last year in South Africa, President Zuma memorably sacked his Finance Minister Pravin Gordhan, saying he was “very busy trying to fix the country” and poor old Pravin got in the way. We know what happened next – Zuma went on to be ousted as leader of the ruling ANC. Things still aren’t certain however, with Zuma hanging on to his Presidency. Political instability is par for the course.
While we leave the quiz question hanging in the air, how about we consider another country currently prey to the whims of an unstable leader?
In this second country, the leader uses Twitter to taunt his heavily armed and equally unpredictable overseas enemies. He uses it to criticise his biggest trading partners. He uses it to lambast members of his staff that he previously hired, but then fired in a fit of pique.
You all know who this is. And he has just replaced the Chair of the country’s central bank. Due to resignations and retirements, he also now has the power to pack it with his own people.
The market is currently pricing an 80% chance of a rate hike from the Federal Reserve in March. This, despite the central bank losing its central triumvirate of the previous administration, with the departure of Yellen, Fischer, and Dudley. Sure, Jerome Powell has been on the Fed Board for five years. But that doesn’t mean it’s the same Fed that will be taking decisions this year. That would even have been the case without the Chair suffering under the patronage of a populist. How can we be sure of anything the Fed will do this year?
Let’s take a thought experiment. Let’s say Powell takes some decisions this year that the Supreme Leader doesn’t like. Maybe he causes the stock market to fall. Given that Trump loves tweeting how new record highs in the Dow are clear signs of his call to #MakeAmericaGreatAgain, is he going to take that lying down? Or will a whisper campaign be started that Powell needs to be replaced? It is difficult to do in practice, as Newt Gingrich found out in 2011 when frustrated by then-Fed Chair Bernanke’s ‘irresponsible’ money printing. The Fed Chair can only be ‘removed for cause‘; or Congress would have to amend the Federal Reserve Act. Oh but what if you have the mouthpiece and the chutzpah to issue statements such as these?
How is a Fed Chair going to make sensible and serious decisions for the future path of the US economy when those around his table and his ultimate boss could claim he’s “lost his mind”? Wouldn’t mental incapacity be cause enough to remove someone? Or at least to undermine his decisions to the point where he resigns?
Wouldn’t this scenario suggest a degree of political capture of the allegedly independent central bank? Wouldn’t it suggest a risk premium might have to be factored into that country’s currency and bonds?
In fact, wouldn’t it be just how we would look at an Emerging Market?
This is how political risk can infect asset prices. If you want to look at surprises for the year ahead, don’t think about fractions of a basis point onto inflation. Think about a wholesale reassessment of the stability of the country into which you and others are investing. Think big. Think about how the US Dollar could be undermined as a reserve currency in this brave new world. Isn’t it better to go for, say, the Euro or the Japanese Yen? The European economy is booming, it has a current account surplus, and the central bank is moving away from QE and negative interest rates. Japan is (almost) following suit. Japan even has stable politics, with Abe having called his snap election. The Japanese Yen could be the year’s big winner.
The European political leaders look stable, with France having avoided Le Pen and Germany apparently proceeding as before with Angela. But there are risks in the EU too: the German SPD don’t necessarily want to form a Grand Coalition, as it hurt them so badly in the last election; but if they do, it would leave the populist AfD as the largest opposition party. Macron and most of his MPs in the National Assembly are entirely untested but trying to push through massive reforms. Meanwhile they have to decide on the future of the EU itself. The SPD’s leader has already announced he wants a “United States of Europe” within eight years. The existential crisis in Europe is real.
…which leads us back to our first question.
Here’s a final clue. This country actually has inflation, which has largely been triggered by a pass through from its significantly depreciating currency. We haven’t yet seen a peak in CPI, as shown by this great chart from Rupert Seggins:
The red line is the effective exchange rate, advanced by 2 years. The blue line is core CPI. As you can see, inflation could easily hit 4% in the months ahead, and that’s without any further impetus from a renewed decline in the currency.
So, who is this country?
- Large current account deficit
- Depreciating currency
- Inflation increasing
- Central Bank hiking
- Politically unstable
- ….and trying to renegotiate a deal with its largest trading partner?
Yes, you’ve got it. The good old United Kingdom of Great Britain and Northern Ireland.
If we can envisage the USD could lose its reserve currency status, then how about GBP suffering from an EM style currency crisis?
Yes this is the Revolution this year: when Developed Markets become Emerging Markets.