As I reflect upon the current economic and political landscape across the world, I wanted to jot down a few thoughts on the next few years while they were still top of mind. I believe that this next year will bring a tremendous amount of economic and political change, more so than in recent years, and it will be important to be aware of some these transformative events. In the future I will update you all on how some of these predictions have played out and do a deeper dive on these areas. This blog reflects only my personal view – and although you may not agree with some of these considerations they may spur some debate.
Negative Interest Rates: Deflation / low inflation will continue to persist in the European Union, which will force the ECB to maintain negative interest rates for the near future (greater than 1 year). This will begin to have unintended consequences on consumer and corporate behavior, as the initial benefits of negative interest rates decline over time. This will change the way the consumers interact with the banking industry (moving more money to shadow markets), and further spur asset bubbles in other sectors of the European economy (as consumers chase yields in other sectors of the economy as the risk-free rate is so low). This will impact banks, insurance companies and sovereign’s returns. This may also have the impact of changing how people think about the future, in terms of pricing. It has the risk of turning into a Japan like outcome, where European consumers are less confident about growth and think negatively about the future in terms of lower prices, salaries and general optimism, which would then lead to lower salaries, lower prices and a reduction in overall economic activity. What’s even scarier is Japan has pursued this policy for sometime, yet is has limited impact! This will also have an impact on how capital is allocated and how business decisions made. As traditional financial modelling/capital allocation of assuming positive interest rates over the life of the project will now need to be re-assessed. In general a pretty sizeable negative for the macro-economic picture that is not fully understood yet.
Health of European Banking Sector: Non-performing loans as a % of total assets for Italy, Greek and Spanish banks will remain high, and only worsen (as a result of shocks like Oil price declines, but there will be other shocks). This will not get better as the overall health of the European consumer (or their ability to pay back these debt is not good) unemployment and the competitiveness of these economies has not been solved for yet. Labor and bankruptcy laws remain outdated, and housing markets and consumer confidence remains depressed. This will continue to impact market confidence in European banks, and will pressure particularly exposed and weak bank stock prices in these countries. The layers of bureaucracy across the European Union, will further make it difficult for these banks to pursue solutions, such as creation of a bad bank (or the US equivalent of TARP) due to restrictions. Several large Italian and Spanish banks will fail in 2016/2017. The tools (e.g., ESM), increased capital and enhanced supervisory approaches (e.g., one European bank regulator for SIFIs, stress tests)
Figure 1: Credit Default Swaps, and Stock Prices for Top 5 Italian and Spanish Banks (as of 5/6/2016), source: bloomberg, yahoo finance.
Unraveling of European Union Project: The failure of several large European banks / and or Grexit/Brexit you name it, will lead to bail-outs or attempts at bail-outs, and will further drag the European sovereign economies downward (which will in turn create additional pressure from the market on sovereign yields). This is further challenged by low growth remains across the EU. Debt burdens continue to rise. Limited federal fiscal authority across the EU and limited tools in general will challenge what the EU can do. Italy will ultimately require a bail-out, which will be the trigger for the collapse of the European Union project. The flawed design of the European Union will ultimately be the root cause here. The bottom line in my mind, is you can’t have Federal monetary policy without Federal fiscal policy.
Nationalism and Civil Unrest Increases across European: Unemployment will remain high in key European economies (right now standards around ~10%, more than 20% in Spain and more than 25% in Greece), coupled with the Immigration crisis in Europe – will lead to a marked shift in the make-up of European Governments – with a general move more towards nationalist and protectionist policies/governments. The political room to pursue European solutions will continue to narrow. Great Britain and Greece will stay in the EU in the near term, yet in the longer term due to the flaws in the European Union, continued economic weakness and immigration/nationalism trends the European Union project will unravel.
Political Landscape in the US Moves to the Extremes: Donald Trump is not elected President. Bernie Sanders is not elected President. But the damage has been done. The US continues to move down a path of increased polarization and rationalization, one that see’s more and more extremes. Social issues will further divide the country (e.g., Gay Marriage, Immigration. Abortion) and increased disparity between incomes, wealth and opportunity between (the 1% and 99% ) will lead to increased violence, more civil unrest and a situation where I would not be surprised if we saw several southern states threaten succession. We are just so far apart, and some of these areas between Republicans and Democrats appear to be non negotiables. Several studies have shown that this has been historically widening over time, with polarization reaching levels never seen before. This will lead to the continued gridlock in Washington and the ineffectiveness of Congress.This will take some time
Student lending is the next asset bubble to pop: With nearly 40% of borrowers from the Governmental Student Lending program in default, and the quality/outcomes from US colleges worsening (e.g., prices increasing for colleges)… students will turn away from College and look more towards practical experiences. The US student loan program will expose US federal government finances to further pressure (as revenues drop and defaults increase on student loans). In a worse case scenario, credit rating of US government is further impacted by this, banks will write-down significant assets
Equity markets drop: S&P will drop more than 15% of the course of 2016 into 2017, largely led by weak growth in China, European bank failures, Political gridlock in the US and other negative economic developments in the US. The market will wake up to the fact that the last 8 years of fiscal and monetary policy have created several new asset bubbles, and the core fundamentals (e.g., productivy, median income growth, unemployment etc.) are not as solid as once thought.
Dodd Frank is here to stay: The complex web of what has been implemented as a result of the US Dodd Frank Act will prove too complex and too opaque to unwind. Regulators not understanding the costs and benefits of regulations (and more specifically how these interact with each other / unintended consequences) means that the US banking system will be burdened with undue costs at some increased resiliency. Does this mean another crisis will be prevented? I think not. In fact as a result of the further politicization of the Fed and pressure from Congress, the Fed may actually lose a few key tools that proved crucial during the crisis (e.g., TARP)
We will deep dive into several of these predictions in more depth beginning with the student loan crisis in the US