Last week, the Federal Reserve announced three rate hikes in 2017, and another three in 2018, with a $600 billion reduction in its balance sheet ($420 billion in treasuries and $ 180 billion in mortgage-backed assets).

The announcement has sparked the concern of inflationists and bubble defenders. A downsizing of the Federal Reserve’s balance sheet! Anathema. As if it had not risen from $900 billion to the terrifying figure of $4.5 trillion, and mainstream analysts are worried about a small decrease. None of them seem to worry about the huge bubble in bonds nor the excess of risk taken looking for a little yield.

Mainstream is so concerned that they have invented a direct correlation of the size of the Fed’s balance sheet to warn of a massive crash in the markets… Except it does not happen. Rates are rising, the dollar is strengthening, the Fed’s balance sheet is shrinking… and stocks are soaring.

Stocks soar because earnings are better, leading indicators improve and financial conditions strengthen, not only because of money supply. Quantitative easing generated inflation on financial assets, while dividends and buybacks created multiple expansion, and now earnings are back to the rescue.

What consensus is worried about is that, between 2017 and 2018, the composition of members of the Federal Reserve will change to a majority that defends sound money, that is, to end the assault on savers and the middle class that QE meant. In the past eight years, fiscal policy in the US has meant an increase in taxes of $ 1.5 trillion and destroyed a similar figure in the value and purchasing power of the main source of wealth of the United States citizen: deposits. The largest transfer of middle-class wealth to the government seen in over fifty years.

The Federal Reserve is already almost 300 basis points behind the curve. It should to have raised rates much faster.

Meanwhile, in Europe, the ECB is not just behind the curve. It is so far away it does not see the curve.

If the ECB continues with its monetary policy while normalization accelerates in the US, the vacuum effect will multiply.

What is the “vacuum effect”? The world’s US dollar supply shrinks as demand for the currency soars, generating capital outflows in countries that are not a global reserve currency and into the US. This vacuum effect, added to the repatriation of dollars from US companies, is a major risk for the European Union. With more than 1.3 trillion euros of excess liquidity in the ECB, the EU would face the opposite scenario. Supply of euros massively exceeds demand.

Some will say it is an opportunity to export more. It just does not happen. European exports outside of the Euro Zone have stalled since the ECB started its quantitative easing program. But what does happen is that international confidence in risky assets denominated in euros diminishes. If it also coincides with a deterioration of solvency indicators – deficit, net issues, interest payments over GDP – this deterioration in confidence can generate a significant risk that, today, few are analysing.

We must remember that the vast majority of global trade transactions are made in US dollar (87.6%, according to the BIS).

Contrary to what many people think, the percentage of global transactions in US dollars is not only high, but has recently risen. In the same period, since 2008, transactions in euros have fallen eight points. It is no coincidence that this collapse in the use of the euro in global transactions, accelerated with the so-called “monetary expansion”.

As we mentioned, the euro risks losing relevance in global trade, and the alleged “export-effect” is inexistent. If the United States finally puts the policy of defending sound money and the savings of its citizens as the center of its policy, it can create enormous uncertainties for a euro that is now used in fewer transactions globally.

You will say that the US cannot survive a strong dollar, but we already dismantled that argument here (“Is the US dollar the new gold?”).

Almost all governments and parliaments in European countries are seized by the single thought the Japan-style futile policy of negative real rates and excess liquidity must continue, despite evidence of the risks it generates, but Japan has huge savings in foreign currency and an enviable financial inflow. The European Union, does not.

If the ECB resists raising rates, when it is an emergency, and reducing asset repurchases, when it has 1.3 billion euros of excessive liquidity, there could be significant risks in a global economy where the euro is an anecdote. If this is a risk with a strong currency, backed by economic powerhouses, imagine what would happen with unsupported currencies, as the European populists want. A disaster.

If we forget the need to strengthen economies before monetary excess ends, the negative consequences will be serious. Of course, when a new crisis arises, some will blame lack of regulation, not reckless policy.

Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).

Image courtesy Google Images

“I check my bank account more than you check your Instagram” Kid Ink

Is the recent rally of European banks an opportunity or a trap? A minority investor told me on Friday that “every time I buy banks, they are going up, but then I lose everything.” He did not understand the volatility and risk , especially when the press would not stop talking about banks “healthy” balance sheets and adequate results.

Let’s start with a general consideration. No, European banks are not fully cleaned up. They continue to accumulate more than 900 billion euros of non-performing loans (NPLs), and generate a return on net assets below their cost of capital. That is, they lose money.

It is true that valuations are not exaggerated, at 0.8 times price to adjusted book value, which is not expensive if you estimate a 9.9% ROTE (return on tangible assets) in 2017 and a dividend yield of 5.4%. The question is whether that ROTE and yield is achievable or sustainable.

European banks are trading at almost a 40% PE discount to US banks, but this discount is justified by the high exposure to European sovereign risk, the burden of NPLs and the very low profitability (Net Income margin is almost zero). In fact, the mistake investors make when talking about “value” with respect to US banking may lead to losses, because that discount has existed since 2001 and has moved close to an average of 20-30%, justified by lower profitability, less flexibility and the valuation of their loans with debatable criteria (instead of valuing them at market-to-market).

But there are positive elements as well as caution. The excess liquidity is at record levels since the European Central Bank Quantitative Easing started, and already reaches 1.3 trillion euros, showing the weakness of the program and its low effectiveness. Negative interest rates have sunk banking profits, with historic declines in consensus estimates. But that monetary ruin is about to end.

Rates are already rising and that means that an increase of 1% can improve EPS of banks by up to 17% , according to the average consensus sensitivities (Bloomberg).

60% of European banks now have more than twice the core capital than in 2012, which means that they are much more healthy, although the problems are not over. In addition, European banks have more than double the amount of short-term liquid assets than in 2012, which can be used for divestments and to undertake capital strengthening.

Today, deposit rates are negative and that is devastating for the financial sector. A higher deposit rate would improve the spread, and this is particularly beneficial for banks in peripheral countries. According to Morgan Stanley, a rise of 70 basis points in the deposit rate would raise the earnings per share of peripheral banks by more than + 15%. Interest rates would remain extremely low, so the impact on the economy would be non-existent, but financial repression would not jeopardize the sustainability of the banks.

Risks should not be ignored.

Today, banks are rallying due to different factors. The positioning of investors is extremely cautious and underweight in the financial sector and even more so in Europe, which can lead to significant capital flows to banks when that negative weighting is reduced in the portfolios.

The banks’ rally is based on a bet on an increase in inflation that may disappoint those who play to it now that oil remains in a lateral-bearish trend and underlying inflation expectations are not being revised upward.

In addition, this rally in banks is supported by another non-fundamental external expectation. The bet that the European Central Bank will aggressively change its monetary policy. All the indicators tell us that it should, that it is urgent and that maintaining it does more harm than good, but we must not forget the risk of maintaining financial repression and real negative rates because European governments are unable to tolerate on increase in cost of debt of 50 basis points. It is important, at least, to know that the rally in the stock market is explained by an inflationary bet and increases in rates in addition to the supposed cheap valuation (banks are always “optically cheap”). Because that “reflation trade” can reverse very quickly.

Let’s not forget another factor. With higher rates and inflation, non-performing loans rise as well, as companies continue to suffer from overcapacity and tax increases.

Banks demanded the ECB’s monetary expansion program, until they realized in horror that negative rates shattered their balance sheet and income statement. The monetary expansion that they applauded until their hands bled almost sent them to the cemetery.

It is not wrong to say that the banking system is much healthier than it was four years ago . Nor is it a lie to say that its structure of balance sheet and profitability is extremely fragile, and that its core capital ratios can evaporate with a small change of the cycle. Therefore, to assume that the era of  huge provisions is over is to be very optimistic. To think that there are no additional capital needs is reckless.

The combination of valuation, improvement of the cycle in Europe, change of monetary policy and return to a certain sanity with interest rates are factors that put banks’ head above water.

As a good friend, investor in the financial sector, once told me “you do not buy banks, you rent them”. Cycles are getting shorter and the challenges of the financial sector are not over, so active trading is recommended.

Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).

Image courtesy Google Images, starecat.com

” If I can not have you the way I want you, I do not want you at all ” Dr. Feelgood

Brexit has been launched. Mainstream consensus is going through the typical phases of anger (“this cannot be”), shock (“only uneducated, old, and fascists have voted exit”), denial (“it will be stopped by parliament or the commons”) and now we approach, slowly, to the phase of acceptance .

And there it is: Article 50.

The first thing we must be is intellectually honest and recognize that the estimates of an economic debacle post-referendum have not happened. The consensus estimated negative impacts if Brexit won the referendum that did not appear anywhere. The devaluation of the Pound is nothing more than losing the premium it reached with against the Euro on fears of the Eurozone crisis, and GBP-EUR trades at average levels of ten years. All other indicators, in the EU and UK, have been strengthening. Growth and job creation in the UK have been revised upward by the Bank of England and investment banks.

The UK economy continues to grow, with a 20bps increase over post-referendum estimates, bringing GDP growth for 2017 at 1.6%. In addition to the recent revaluation of the Pound against the Euro, we have seen a similar improvement in estimates for the European Union, where GDP growth expectations have been revised up to 1.6% for 2017 and 1.8% for 2018.

So all is good, is it not?

The truth is that all this happens because there was already a very independent framework in the UK and a dynamic economic environment that makes the risk much lower. But we cannot forget that the arrival in the US of the Trump administration adds an essential support to the UK that mitigates risks.

The fact that these concerns and doom expectations have not yet manifested does not mean that risks do not exist, especially in the face of a tense, long and hard negotiation in which both sides have very different positions. Add to all this the calls for referendums from Scotland and Northern Ireland. In the UK, oddly enough, many see a separate Scotland as a historic opportunity for Labor to disappear from the options of government in England, as Scotland is a stronghold of the left.

It seems that the process of reaching agreement can last between two and three years, a period that will surely be full of aggressive messages in the media.

The European Union will not want to leave a bad example of weak negotiation in order not to generate a domino effect, as it faces the rise of internal Euroscepticism. If the European Union was smart, it would use this opportunity to strengthen as an area of freedom, flexibility, attractive investment and global trade. If it falls into the mistake of using the excuse of Brexit to advance in what some call “more Europe” -which means more bureaucracy and interventionism-, the EU is bound to fail. More Europe should be more investment, better employment, and stronger growth,

More Europe should be more investment, better employment, and stronger growth, fewer taxes and burdens, not more committees, taxes, and subsidies.

Expect a couple of years of uncertainty, but let’s be honest in narrowing expectations, both optimistic and pessimistic ones.

Exports and imports

UK production only reduced 0.4% using official data, in the first months of 2017 , due to a decrease in the pharmaceutical sector of 0.9% due mostly to the uncertainty of the Trump healthcare plan, not from Brexit.

The UK trade deficit has fallen to 4.7 billion pounds in the three months to January. Exports have grown at the fastest pace in ten years in the quarter, reaching a record high, and imports have also skyrocketed. Therefore, the impact on trade that many predicted is nowhere to be seen at the moment. The UK is one of the biggest trading partners of the EU, and it will continue to be.

Who pays?

The United Kingdom is the second largest net contributor, after Germany, to the EU budget. That cost will have to be distributed among the others, and Spain, for example, would have to pay around 1 billion euros more per year.

Immigration

An extremely important topic. Net immigration from Europe to the UK has more than doubled since 2012, according to a report by Capital Economics, reaching 185,000 people. Total net immigration has also skyrocketed, reaching more than 320,000 people, compared with a historical average of 150,000, according to the British government.

The free movement of citizens and the rights of EU workers in the United Kingdom and those of the British in the rest of Europe will likely be the ace card used to accelerate negotiations. The UK does not want to outsource its immigration policy to the European Union, as it does not have a clear one or exercise leadership in the face of geopolitical challenges. Be that as it may, the days of the free movement of workers are over, and a policy similar to that of the United States could be expected.

Trade

Nearly half of UK exports go to the EU, but -disaggregated- of the 28 countries, 26 have huge trade surpluses with the United Kingdom. What does that mean? The EU, country by country, exports more to Britain than it imports. That is important, especially with the country that has the largest surplus with the UK, Germany.

The UK has a high deficit in trade in goods, but a huge surplus in services. All this means that the exit from the single market can have an impact, but that the solution for each other depends on a fast and specific agreement for the United Kingdom.

Financial sector

With the latest data available, the UK exports 19.4 billion pounds per year in financial services to the EU, a surplus close to 0.9% of GDP. This is a big stumbling block. It is not clear if financial institutions will have a passport to operate with the EU or if the finance sector will face limitations. The United Kingdom originates almost 20% of loans for EU infrastructure projects, according to the City report.

Regulation

According to Capital Economics and Open Europe, the cost to the UK of the 100 most expensive rules and regulations of the European Union is 33 billion pounds a year. Excessive bureaucracy and high taxes have limited potential growth and investment in Europe, particularly in the past eight years.

If the European Union does not take the initiative and begins to dismantle the bureaucratic ‘leviathan’ it has built, this cost will be a problem for many countries. But then, we must not miss out on the fact that the UK is already one of the leading countries in ease of doing business. Therefore, eliminating unnecessary regulation and bureaucracy is one of the aces up the sleeve to attract investment to the UK post-Brexit .

Foreign investment

The European Union accounts for almost 46% of foreign investment to the United Kingdom, mainly due to the purchase by multinational companies of other British companies. This flow is not expected to be reduced and, of course, could be easily replaced. European investment has already reduced in recent years and has been more than offset by other countries.

UK investment into the EU will not likely be reduced due to Brexit. If anything, it will increase, given the opportunity to develop activities within the EU and move part of some businesses abroad.

We are approaching a period of maximum uncertainty, but the opportunity is enormous. The European Union can come out of these negotiations strengthened, learning from its mistakes, reducing bureaucracy and attracting investment and capital. It is also an opportunity for the UK to thrive.

I believe Brexit is not going to be a zero-sum game. The challenges presented are only opportunities. If we take them, it is a chance to grow, be more prosperous, and regain leadership. If the bureaucrats see an opportunity to advance in the wrong union project, consumed by interventionism and high taxes, all Europeans will be guilty of our own failure. I believe that the European Union should leave its cave and become a world leader in trade, growth, employment and investment attraction.

Let us not fall into the mistake of thinking that the European Union is marvelous and the British are wrong, that the union must remain a bureaucratic dinosaur. As they say in England, “hope for the best, but prepare for the worst “, because the combination of arrogance and ignorance is very dangerous.

Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).

Image courtesy Google Images, starecat.com