Political Risk in Spain--Changing the Narrative

I’d love to continue the great inflation debate of 2017, with more and more charts and links to arcane central bank papers.

But wait, there’s more!

“Eurozone Inflation Points to ECB Caution on Quantitative Easing”

Wall Street Journal, September 29, 2017

Good grief, can someone drive a stake through the heart of this inflation theme?!?

As if by magic, Trump’s tax plan and the Catalonia gonzo-referendum charge into the macro fold to fight with the Fed and inflation for breathing space in the minds of investors. And don’t forget the German election could portend a stronger fiscal easing with the Greens and FDP joining to push for more spending and tax cuts…Merkel might be the world’s only political leader that needs convincing to spend a budget surplus to strengthen an electoral coalition, but I think it will happen.

By contrast, I’m skeptical on the Trump tax plan--not only on the execution, but also on the growth implications. There simply aren’t enough grown-ups writing this bill to craft something materially growth positive for an economy like the US.  The attribution of the selloff in rates over the past couple of weeks can be shared by the FOMC and tax reform, but I don’t think the market is pricing in faster growth or higher deficit spending so long as 5x30s is still stuck in the basement.

Given the way fast money ripped FVZ7 coming out of the fed meeting, I thought we’d see 5x30s grind higher….but no!  

Circling back to Europe, the combo of the weak inflation data and increased political uncertainty after the Catalonia referendum will put a cap on the strong EUR theme for now.

Rajoy clearly overplayed his hand, but it is far from clear what the next step will be. Political deadlock and delay seems to fit for Rajoy--and while this was a victory in the media for the Catalan independence movement, it isn’t clear what the next step will be. Will the Catalan leadership throw gas on the fire and declare independence, as promised before the referendum, and suggested by Puigdemont today?

That would be a big sell signal for peripheral spreads and EUR. Time will tell, but I don’t believe the “strong Euro” trade will take the spotlight again until there is a political solution and/or economic data to change the narrative. That could be good news for EMFX, since an increase in political risk amidst continued positive global growth signals could shift more of those RM flows into EM.

That being said, The New York subsidiary of Team Global Macro didn’t join the "buy USD" game today. EUR gapped weaker on the Asia open and it was “sell on” to 1.175 for the London open...but then...nothing. Choppy trading throughout the day and a steadfast refusal to break the 1.17 support I noted earlier last week.

Yet there is plenty of space to see a further selloff in peripheral spreads, especially as the next risk-event in Europe is likely to be the Italian election early next year, which could usher in a squirrely Eurosceptic populist coalition that makes the Tories look like a poster child of political unity and discipline.

10y bono-bund spreads sold off 8-10bps today, but still well off the wides from earlier this year. With the withdrawal of the 2018 budget amidst opposition from the Basque nationalists, there seems to be scope for continuing widening. Given the firmly entrenched BTD mentality, I’d be loath to say we won’t see real money buying, but it may take more cheapening for them to step in.

This regression is plotting the current level from Friday’s close but illustrates there isn’t much value in Spain, even after this back up. Come to think of it, if this regression shows one thing it is probably that there hasn’t been much credit analysis going on in the periphery at large since the Italian referendum.

As discussed in previous posts, earlier this year the strong EUR theme had the potential to have some momentum behind it, given the unwind of the structural short in the market after years of getting kicked around. A couple of charts from citi’s macro group show that theme gained traction as the European economy picked up speed while the US disappointed--that divergence in the data appears to be mean-reverting and indeed, RM flows are slowing down. That short-term technical is USD supportive as well and points to a break of that 1.17 level.  

In other news….just a quick “clip and link” to a chart published today by Scott Minerd over at Guggenheim and brilliantly titled, “Stocks for the Long Run? Not Today.” The expected 10yr return for the S&P 500 has dipped below that of 10y UST, which is a big negative for risk-adjusted equity returns.

I noted this fact a while back in my discussion on the risk appetite, reach for yield, lousy returns, and lust for private equity among pension funds, high valuation by definition means lower future expected returns.  Pension funds can’t wish this problem away by taking more exotic equity risk, more duration risk, or in my opinion, more exotic fixed income risk at Minerd suggests. While I agree that he is probably right about value in off-index cash flows relative to those inside the Bloomberg Barclays Global Aggregate, long-term investors need to temper their expectations for future returns and not shy away from tail hedges that will protect them in a downdraft at a reasonable cost.

Shawn
TeamMacroMan2@gmail.com

@EMInflationista