IIF Authors

Status: Will be live at 05/26/2016 00:00

Weekly Insight: Views from Madrid

Thursday, May 26, 2016

*' Equities in a sunnier mood

* May flash PMIs-diverging paths

*' Brazil-a win for the government

* The Greek deal-disbursement welcome, but not much debt relief

* Our Madrid SMM-macro, markets, politics, fintech!


' 1. Equities in a sunnier mood:'While the discussions at our IIF Spring Membership Meeting focused on the challenges facing global policymakers (see below for our wrap), world equity markets have posted solid gains this week (up over 2.5%), with U.S. banks in particular cheering the prospect of a near-term rate hike (Chart 1.1).'  A number of Fed officials have played down external risks (e.g. Richmond Fed President Lacker, who noted such risks had "entirely dissipated"), while talking up prospects for a June/July rate hike-San Francisco Fed President Williams emphasizing that there could well be two or three rate hikes this year.'  But rather than quailing as was the case last week , equity markets now look to be interpreting this as a vote of confidence in the resilience of the U.S. economy, with collateral benefits for the rest of the world. '

IIF Global Equities

Although May PMIs were a mixed bag (see below), a solid upturn in the U.S. and Euro Area economic surprise indices in recent weeks has also helped the mood.'  And while perceptions of China-related risk remain elevated, broad currency market volatility has declined, notably so for sterling as recent polls suggest the risk of Brexit has abated somewhat (Chart 1.2). Oil price volatility has declined markedly as Brent crude continues to edge towards $50/barrel (see views from our SMM panelists below).'  However, equity analysts remain cautious: with trailing earnings still very weak (down 15% yoy in mature markets and 12% yoy in emerging markets), downward revisions to next year's earnings estimates have continued in May (albeit at a slower pace than in Q1).'  Higher stock prices and lower earnings projections have left valuations well above their January lows-notably so for the U.S. (now trading at 18x forward earnings, well above the 15x average of 2005-15).'

Volatility: Currency Markets and Oil Prices

With interest rate support back in play, the U.S. dollar has continued to climb, and is now up nearly 3% on a trade-weighted basis this month.'  The euro and many EM currencies have been harder hit, while the yen and sterling have gained ground (Chart 1.3).'  Losses for the Mexican peso (-7% this month, trade-weighted) have been sharp enough to trigger speculation of an unscheduled rate hike. In response, Banxico Governor Carstens noted that the peso losses were driven by fundamentals (2017 growth forecasts were cut by a quarter' point to a 2.3-3.3% range in the latest inflation report).'  While he did not rule out intervention to support the peso under "frankly exceptional" circumstances, Governor Carstens expressed a strong preference to keep interest rate adjustments to scheduled meetings (next one is on June 30). '


More broadly, EM equities continue to underperform, while currency weakness has prompted selling in EM local currency bonds-down 5% over the past month, while EM hard currency and mature market corporate bonds have held up better.'  Deteriorating sentiment towards emerging markets is reflected in our high-frequency tracker: as the FOMC leaned more hawkish, last week saw the largest weekly non-resident portfolio outflow since January from the sample of EMs which' publish daily data ' (Chart 1.4). Last week also marked the fourth consecutive week of outflows following a period of eight straight weeks of inflows. Full coverage can be found in our upcoming May' Portfolio Flows Tracker.

Weekly Non Resident Portfolio Flows to EMs

2. Flash PMIs - diverging paths:' This week's Markit flash PMI readings for May were marked by divergence across sectors and countries. Looking first at manufacturing conditions, Japan's PMI dropped further into contraction and the U.S. manufacturing sector slowed further, providing little hope for a pick-up in industrial production, which rose only 0.5% oya in April. The pace of contraction in France's manufacturing sector eased but the German print beat expectations, rising further into expansion territory. The Euro Area aggregate manufacturing PMI dipped slightly, but maintains a constructive level at 51.5 (Chart 2.1).

Manufacturing PMIs

Services PMIs, which have been more resilient over the past year, continued to be a source of strength - particularly in the Euro Area. Germany's services PMI showed further robust expansion, while the French PMI rose too. Both outcomes were well above consensus, and left the Euro Area aggregate nearly unchanged at 53.1. In the U.S., the services PMI dipped, missing expectations by the most in at least 2 years, ' but remained solidly in expansionary territory (Chart 2.2).

Services PMIs

3. Brazil - a win for the government:On Wednesday the Brazilian congress approved a revised budget plan for 2016, which brought a positive reaction from markets with both the real and Bovespa gaining ground (Chart 3.1). The 2016 public sector primary deficit target was revised to 2.7% of GDP from 1.7% to account for worsened growth. The new administration has also announced several measures aimed to restore investor confidence: (i) reducing budget rigidity by delinking a greater share of earmarked revenue from mandatory spending; (ii) detaching social benefits from the minimum wage; (iii) capping growth of public sector primary spending; (iv) reforming the pension system by increasing the retirement age; (v) granting legal autonomy to the central bank; (vi) retrenching subsidized credit from BNDES, who will also prepay their debt to the Treasury, and other public sector banks; and (vii) increasing the private sector's role in infrastructure as well as in exploration and production from pre-salt offshore fields. While fiscal realism is welcome, quick delivery, which could prove challenging as several of these measures are politically difficult structural changes requiring congressional approval, is essential for regaining confidence.


The unpredictable unfolding of the Lava Jato corruption probe remains the greatest risk to Temer's administration and, therefore, on fiscal consolidation. The recently appointed Planning Minister had to step down amid allegations that he attempted to obstruct Lava Jato investigations. His prompt departure reflects the administration is keen to distant itself from the Petrobras corruption scandal. Extreme political skills will be required to deliver announced fiscal structural measures while corruption investigations remain unabated.

4. The Greek deal-' disbursement welcome, but not much debt relief:'The Eurogroup creditors, IMF and Greece have reached agreement on'  the first review of the third official assistance program, thus releasing '‚¬10.3 billion of needed liquidity from Europe to'  Greece (in 2 disbursements, '‚¬7.5 billion in June and the remainder in September). However, instead of unconditional and upfront debt relief advocated by the IMF, the agreed debt measures are vague, conditional and contingent, and stretched over a long period of time. Basically, the Eurogroup has promised sufficient debt measures to ensure that Greece, if they continue to meet program requirements, would keep their Gross Financing Needs (GFN) below 15% of GDP until 2040 and below 20% of GDP until 2060.

In the short term (until late 2018), the debt measures are modest: extending the weighted average maturity of EFSF loans from 28 years to the maximum allowed 32 years and abolishing the step-up in interest in the debt buyback tranche of the second program.

In the medium term and subject to Greece meeting the primary budget surplus target of 3.5% of GDP by 2018 (Chart 4.1), the Eurogroup will consider turning over to Greece the 2014 ECB's Securities Market Program profit worth '‚¬1.9 billion; using the unused portion of the ESM program ('‚¬19.6 billion to refinance more costly official loans from EA creditor countries); and if necessary, reprofiling EFSF loans (extend maturity, cut interest rates and give grace periods).

Greece: Primary Balance

In the long term (beyond 2040) the Eurogroup agreed to have a "contingency mechanism on debt" to be activated to ensure debt sustainability if an adverse scenario materializes.

On that basis, the IMF management has agreed to recommend to its board to participate in the third program, subject to a new staff DSA taking into account the debt measures.

In short, the disbursement of funds is welcome as is the expected decision by the ECB to accept Greek government bonds as collateral in its regular bank funding facility. These measures will help Greece stabilize and recover into 2017. On the other hand, the modest debt measures-especially in the short term-as well as the reliance on a large primary budget surplus target will continue to act as a headwind to any Greek recovery effort.

5. Our Madrid SMM-' macro, markets, politics, and fintech!' Over 650 members and official sector guests joined us in Madrid this week for our Spring Membership Meeting. During two days of lively, interactive sessions our industry CEOs and leading analysts had frank discussions with senior regulators and policymakers. We offer here some of the highlights.

A key theme of our Future of Europe panel was, unsurprisingly, the potential consequences of aBrexit(Chart 5.1).'  Panelists including former UK Cabinet Minister Ed Balls argued that the June 23 referendum-even in the event of a "Remain" vote-would not settle the British relationship with the European Union once and for all. Indeed, the next Conservative prime minister could be a "Leave" supporter, and hence the question could be brought before the British voters again. While the economic arguments support "Remain," the "Leave" arguments, including'  sovereignty and curbs on migration are central to many of the issues confronting the EU (see our new report ,"Vote of a Lifetime: Financial Sector Views on Brexit").'  If the response of the Eurozone to a Brexit is to move closer together and increase integration, this would make life even tougher for the few remaining non-euro EU countries-including Poland, observed NBP Governor Belka.

Brexit Remain or Leave Poll IIF

Our panel on Europe's economic outlook agreed that the consequences of a Brexit would be negative, mostly felt through the banking system, and would hurt the British economy much more than the rest of the EU.'  Theimpact of regulatory change on the financial sector-a theme discussed throughout the conference-spilled over here to the economic debate, as the continuous stream of regulation was seen to be reducing the ability of financial firms to support economic growth in the Euro Area. Panelists questioned whether the cumulative impact of financial regulatory reform-interacting with slow growth and extraordinary monetary policy-is actually a headwind for banks in terms of earning ROE sufficient to cover their cost of capital.'  This may be particularly the case for European banks.'  The panel broadly agreed that the benefits' of' low/negative interest rates'were outweighed by the negative side effects, and that the ECB should move away from this policy. ' However, such a shift could lead to a challenging euro appreciation unless the Federal Reserve is seen as continuing down the path of policy normalization (Chart 5.2).


A number of distinguished official sector speakers emphasized the need toreinforce the underlying architecture of the European monetary unionto increase resilience and raise growth potential (Chart 5.3).

Euro Area Actual and Potential Growth

In his remarks Banque de France's Governor François Villeroy de Gaulhau called for greater coordination of national policies, including by establishing a European Finance Minister who would be responsible for putting together and supervising the implementation of a collective strategy for fiscal and structural policies to complement the ECB's role on monetary policy. This would generate more symmetric incentives that could for example encourage greater fiscal support in Germany and greater reform progress in France. The Minister could be responsible for a Euro Area convergence fund that could help centralize crisis management and provide a common countercyclical instrument. He also called for steps to encourage the increased availability of equity financing for investment in Europe, an area where Europe fell far behind the U.S., for example by tax reforms and encouraging more cross border equity flows.

In his turn on stage, Peter Praet, chief economist and member of the ECB executive board, also pressed for opening up cross-border financing. He placed'  particular stress on the need to encourage a trulyEurozone-wide banking systemwhich would improve the transmission mechanism for monetary policy and increase resilience as bank balance sheets would be less exposed to national risk. While progress has been made towards a single supervisory mechanism there remained work to be done to allow banks to manage their operations on a truly European basis. In the conversation Tim Adams observed that a move to more European wide banks would require less resistance to large-scale banks. Peter Praet recognized this point, observing that banks should be scaled against the Eurozone economy as a whole rather than individual national economies-in that context they would have considerably less systemic importance (Chart 5.4).' '

Size of banking sector

Both Praet and DNB Governor Klaas Knot emphasized the importance of moving towards well-functioning banking and capital markets union. While acknowledging the political challenges, Knot also observed thatcloser integration-including via a common European budget-would greatly enhance the stability of the union.'

Outside Europe our panels looked at developments in China and the MENA region.'  Our China experts downplayed the risk of a hard landing, arguing that policymakers will focus on keeping growth above potential through accommodative fiscal and monetary policies.'  However, the overall quality of growth has been disappointing and the rebalancing scorecard is mixed, suggesting more risk in the medium term. Corporate deleveraging is also a policy focus but will be gradual to avoid any significant rise in systemic risk. ' Although bond market reforms are heading in the right direction, policy makers are unlikely to remove implied guarantees for large scale SOEs. Progress on structural reforms has been slow, especially on SOE reforms. Capital account liberalization will remain one sided and focus on attracting inflows. However, capital outflows should remain quite high despite the recent moderation and the RMB is likely to continue to depreciate against USD (Chart 5.5), particularly given the more hawkish tone of recent Fed commentary.'

Chinese RMB vs Basket

While lower oil prices represent serious challenges for Saudi Arabia and other countries in theMENAregion, including deteriorating fiscal balances, these look manageable amidst low debt levels and large official international reserves.'  Moreover, low oil prices offer a unique opportunity to develop domestic capital markets and diversify the economy at a time when the population understands the need for change. However, the pace of implementation could be much slower than that set out in Vision 2030 , as the lack of human capital remains the biggest structural challenge. Iran's economy is already well-diversified and with the repeal of sanctions, oil-related economic activity will likely to increase despite low oil prices.

In ourcommoditiessession, leading oil market analysts set out the case for prices to move higher in the near term, perhaps to the $55-60 per barrel range by year (Chart 5.6) end as the supply glut of recent years shifts closer to a temporary balance-helped by cutbacks in U.S. shale oil production and a number of supply outages. However, they were much more cautious about the medium-to-longer term (no return to $100 oil), making the case that production was likely to ramp back up in the U.S. and that many exporters, including Russia, Iran and a number of poorer oil producers, have strong incentives to keep production high.'  A greater focus on climate change and green energy sources over time will also keep downward pressure on fossil fuel prices-though natural gas could benefit.

Oil Price and Forwards

Turning to theU.S. political scene-in a spirited exchange, panelists predicted "the most negative election campaign in modern American history."'  Former Assistant Secretary of Commerce Bruce Mehlman suggested that for IIF the two key conclusions are "(1) markets under-appreciate Trump's electability and (2) business, especially Wall Street, will enter 2017 with its fewest allies in Washington in decades."

Panelists agreed that by all the previously-understood rules of U.S. elections, Clinton is better-positioned: she has more experience, a stronger organization, more robust fundraising and an opponent viewed more unfavorably than any nominee in history.'  Clinton is particularly strong among women, non-white voters and millennials, the same coalition that elected Barack Obama twice (Chart 5.7).

U.S. Elections

Yet 57% of voters want a candidate who will drive change rather than one who brings experience and stability, and voters favor Mr. Trump 55-22 on the ability to "shake things up."'  Secretary Clinton is "perhaps the most Establishment candidate to run for President since George H. W. Bush in the most anti-Establishment year since 1976."'  57% of voters say that she is untrustworthy.'  She will enter the general election having lost 42% of her party's vote to Socialist Bernie Sanders.

Regardless of who wins, the winds are clearly shifting on several policy items.'  Longstanding American support for trade deals will likely give way to greater emphasis on trade enforcement including allegations of currency manipulation.'  Both nominees oppose the Trans Pacific Partnership agreement and both support taxing Wall Street more aggressively.' Immigration reform and the extent of America's engagement in the world likely depend on the election outcomes, with Trump far less internationalist than Clinton.

Technology-driven changecontinues to be a priority on the industry agenda. ' There was standing room only for our fintech panels on' blockchain and alternative lending, themes also' emphasized during several lively discussions with leading C-suite speakers on the future of finance. ' Many cited progress in the industry around engaging key technological developments, though acknowledged the real challenges facing IIF members around implementation and internal' transformation.'  As one speaker said, it's not a technology challenge-it's a cultural challenge.' '

Benoit Legrande of ING highlighted the role of partnerships with tech' firms including alternative lenders, to help' firms innovate to' meet market demands. ' DAH's Blythe Masters focused on the need for a blockchain infrastructure to fundamentally change cost structures in a low ROE environment (Chart 5.8).' ' DeepMind's Shamil Chandaria described the' AI breakthroughs that enabled Alpha Gos victory over legendary Go player Lee Sedol.'


Ayasdi's Gurjeet Singh and IBM's Jean-Phillipe Desbiolles outlined both the long-term potential of AI in finance, as well as shorter term opportunities to use the technology to' address regulatory and compliance challenges.

A' key takeaway is the need for' serious industry-level engagement of' the public sector on regulatory approaches to new technologies.


What to Watch for Next Week

Monday:Japan IP (Apr); Spain and Germany Inflation (May)

Tuesday:Australia, Canada, and India Q1 GDP; China PMIs (May); Indonesia Inflation (May); France, Italy, Euro Area Inflation (May)

Wednesday:Brazil Q1 GDP; U.S. ISM Manuf. PMI (May)

Thursday:Euro Area Interest Rate and Press Conference

Friday:U.S. Employment Report (May); U.S. ISM Non-Manuf. PMI (May)