Theresa May´s Tuesday speech on Brexit was clearly firmer and more aggressive than many expected.

The pound’s reaction, triggered by May’s words, was the clearest example of a rebound caused by the previous buildup of short positions in the currency -particularly vs Euro- into the speech. As soon as messages of support for investment and global trade were launched , many of these short positions were undone, causing a squeeze. In addition, Anthony Scaramucci in Davos announced that a US-UK trade agreement could be completed in six months, which for many was a positive shock. But the pound fluctuations are not so relevant. It has been trading close to 10% of the average levels of the past eight years.

It is clear that Theresa May has made a strong and confrontational speech, showing no flexibility with respect to the European Union, because she perceives a strong support from the US post Trump, as well as a vast opportunity as a global trade power force. In my opinion, it would have been hard to hear sentences such as “to continue in the single market would not be a Brexit at all” without a strong view of trading opportunities with the US, Asia and the Commonwealth.

May launched a battery of proposals that were clearly targeted to her electorate and the advocates of Brexit . If it had been more conciliatory, brexit supportes would have felt very disappointed, and remainers as well, because they do not accept “half Brexits “.

I would like to highlight the words of Scaramucci at Davos. He is a great fund manager and Trump advisor with whom I shared a couple of slots at CNBC in London. His words are very important, because one of the negative arguments regarding Brexit has always been how slow and difficult it is to close bilateral treaties. Obama even threatened with years of negotiations. Trump, on the opposite side, promises an agreement in a few months. Carl Icahn has always said that the only reason why bilateral treaties are delayed is because there are many committees to pay.

Theresa May might have another ace up her sleeve when she announces her “no single market, thank you”. The vast majority of the countries of the European Union have a massive trade surplus with the United Kingdom, especially Germany. That is, they export much more than they import from the United Kingdom. This is why many assume that closing bilateral agreements will have to be easier and quicker than feared. Although the idea has merit, it is not that easy. The European Union is not solely guided by economic benefits and trade, and in this particular case, it could be one of those moments in which Brussels prefers to lose a few billion in commercial activity than to give up power.

May’s speech shows that the overriding priority is to have independence with respect to any and all EU bodies, and that any other consideration is secondary.

When she commented that the parliament would decide on the agreement, many thought that this would lead to a negative vote and no Brexit. However, there are numerous analysts who believe that in the next months, the reasons for wanting to remain in the European Union may continue to weaken -immigration, interventionist populism growing, low growth, banking crises- while the reasons to get out will strengthen. I, personally, believe no one is fully right and that neither Europe will worsen nor the UK collapse. But the fact is that many are convinced of a pro Brexit victory in parliament if the deal is good for the country, especially after recent comments from the Labour leader, Mr Corbyn, defending sovereignty in immigration.

Additionally, May puts an important proposal on the table. To have full control of regulation and taxes that would make the UK a global investment and capital attraction centre.

On many occasions we have discussed in this column that Brexit is an opportunity for Europe to eliminate barriers for growth and lower taxes to boost the economy. When we analyze, we must be aware that the risk is twofold, as businesses could also decide to leave the EU if conditions for investment worsen. That is why I prefer to believe in this process as a growth opportunity for everyone than a zero-sum game where one loses what the other gains, as some want to paint it. There are, of course, very important possibilities for business and attracting talent to Europe, but only if we are able to show that we compete in ease of doing business and job creation.

Analysts have been horribly wrong about the negative effects that the referendum outcome would have on the UK economy . All macroeconomic data, consumption, employment, etc. have been much better than estimated and miles away from the debacle anticipated before the vote. But the fact that catastrophic predictions were embarrasingly wrong does not remove very important challenges from an unfriendly negotiation.

Europe cannot sit down looking away, thinking the rest of the world is wrong. It is a golden opportunity to understand the challenges that Trump and Brexit mean and the importance of tax cuts that Draghi, companies and families demand. It is a golden opportunity for Brussels to reconsider and understand that the EU can suffer from substantial capital outflows. Nomura estimates a loss for the EU of 63 billion dollars just from the repatriation of funds to the United States. Imagine if business conditions and regulation are proven to be uncompetitive.

The UK proposes a 17% corporate tax cut, the US as well. Israel will lower it to a range of 4% to 12%. Seriously, if we think that there is no risk of capital flights from the EU with 25% to 34% tax rate and more than 12,000 limits and barriers for trade, we are very wrong.

Let us hope that everyone involved sees these challenges and proves to the world this is an opportunity to learn from past mistakes, improve competitiveness, business attractiveness and employment. That will be the victory for all of a process in which we can all win if we focus on growing, not on “beggar thy neighbor” strategies.

We need to be alert, because the European media talks only about a Brexit where companies and capital movement is in one direction, and it may well be the opposite. Let us show that all economies can be strengthened from supply-side measures, fiscal expansion and economic growth, not growth of bureaucracy.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Picture courtesy of Google Images

Every January comes with estimates of corporate profits and macroeconomic projections, which are essential to determine whether or not the stock market is cheap or if the economy is improving.

However, every year as well, especially in the past eight years, we witness a very entertaining pattern. Massive downward revision of corporate profit expectations. These have averaged 15% between January and December almost every year.

The mainstream consensus of analysts suffers from the same constant mistake of large international organizations, whose average accuracy in their short and medium-term predictions is less than 26%, as Ned Davis explains in “Being Right Or Making Money”. The error of the “double trap”: Long-term optimism and negation of short-term trends.

If we take Bloomberg’s earnings per share estimates for the Eurostoxx 50, for example, in January 2016 for that same year, these were + 1.5%, and + 12.4% for 2017.

If we then look at the same estimates for the same index on December 16, 2016, what do we find? Profits for 2016 -2.3% and + 11.1% for 2017.

This trend is very similar with S&P profits. Full Year 2016 from +2.7% in January to +0.1% in December and FY17 from +14% to+12.3%.

Note the brutal impact on the estimates in eleven months of profits for the very short term. From healthy profit to loss or no growth. But note, in turn, the gradual but inexorable erosion of estimates for the following year.

Graph: Consensus estimates of EPS (source: Citi)

Why is this happening? The “hockey stick” in future estimates is the best excuse to justify blunders.

Look at the examples in macroeconomic estimates, from the Federal Reserve to the ECB and the IMF . The Federal Reserve has been cutting one-year-forward estimates by up to half since 2009. What about inflation estimates? The same.

Ignore for a second the disaster in prediction track-record, and focus in the shape of estimates. Almost always a hockey stick.

Suppose, as with the aforementioned estimates, that we economists have screwed up in the current year. What is the answer? “Oh, but look, next year everything improves.” And, in turn, the next hockey stick is moved to the new, lower, base. But that hockey stick of fantasy future projections, remains. Don´t worry, “next year” will always be there.

There are various reasons:

Mainstream consensus tends to overestimate the positive impact of monetary policy over other risk factors. It is very evident in corporate profits and even more so, in capex estimates. According to Standard and Poor’s, capex predictions have been particularly erroneous.

Since 2012, consensus predicted increases in real net investment, and it fell, very severely in the last three years in particular. As one great US fund manager said: “Come to me with ceteris paribus and I give you zeros salarius”

Analysis houses often introduce large impacts on GDP, consumption, unemployment, and investment or inflation expectations due to changes in monetary policy, without addressing much more relevant trends such as overcapacity, ageing, technology or the real cost of capital. The results are invariably downward revisions, but gradually – little by little, month by month – in order not to look so bad.

Denying business cycles is another mistake. Cycles become shorter and more abrupt as debt rises and money velocity falls. Using estimates where the starting point is simply moved lower and then increased annually, as if there were no cyclical factors that cancel those correlations, is a more than common mistake.

Additionally, the confirmation bias is very evident in these errors in expectations. Assuming short-term mistakes are just anomalies, white noise, that do not change the medium-term prediction, because most of consensus supports the starting premise and it needs to be reaffirmed.

Of course, in order to justify these brutal deviations in short-term estimates, mainstream consensus will use sentences such as “it could have been worse”, “fundamentals have not changed”, and “in the long-term it will improve”.

In order to support the “eternal hockey stick”, there will be seemingly robust studies of regressions, endless Excel spreadsheets and complicated algorithms in which everything appears very scientific until you see that in two or three cells most of the key “inputs” are subjective.

I remember that three years ago I was surrounded by colleagues, former members of the Federal Reserve, when we entered into an endless discussion about business profits and growth in Japan. One of them sent his model of the country and Nikkei companies. It was very complex. Until we found the cell that changed everything. “Expected increase of real consumption from variations in money supply”. Depending on what one decided to input, the country and its companies were still stagnant or booming.

Another magnificent example of the “surprise cell” from those same colleagues came from estimates of US economic growth. “Expected net change in investment from non-financial sectors as a percentage increase in money supply”.

These are anecdotes, but they show that the general mistake in medium-term estimates comes mainly from altering the result to justify the conclusion, albeit involuntary, due to individual prejudices, peer pressure and ideological preferences. There are many studies  that warn of the “pollution” in optimistic estimates, where many of these predictions simply seek to justify an existing policy or strategy, or, in the case of corporate profits, justify valuations that are hardly supported by fundamentals. Any analyst in the world knows that, on average, 80% of the valuation of a stockis explained by the years that exceed the “forecast period” (normally four, maximum five years).

Does this mean that analysis is useless? Not at all.

Analysis has an enormous value in what has to do with the detailed study of factors that affect companies, governments and families. But predictions, especially for more than three years, have to be taken not with caution, but with the certainty that they are contaminated by optimism. To be guided by long-term predictions of economists that deny cycles and are clearly unable to predict the most immediate future is, at the very least, dangerous.

Making estimates is essential for economic analysis. It helps us realize where we are wrong, and act accordingly by recognizing those impacts – positive or negative – we missed, for further analysis. Making mistakes is essential to improve. The problem is to confuse estimates with infallible magic predictions and, even worse, to cover these “hockey stick” estimates with a fake “scientific” layer, when they only serve as an excuse to perpetuate erroneous policies and recommendations.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Pictures courtesy of Business Insider, Citi, David Stockman

Last week, the Central Bank of Mexico intervened twice attempting to defend its currency  with more than disappointing results. The Mexican peso has suffered one of the largest devaluations of any currency in the past twelve months, only comparable to that of the Turkish Lira, and weakened again shortly after the interventions.

Despite these measures, the local currency continues to be under pressure and the cause is mainly the United States rate hike.

On the one hand, Mexico suffers, along with the rest of emerging markets, from capital outflows due to the rise in interest rates in the US.

As US ten year bond yield rises, emerging market debt loses its appeal, especially at current levels. These countries had seen a record inflow of capital over the past eight years thanks to excess liquidity and lower rates in the US, and issuances yield fell to a 30-year low. Today, even at 7.6% these rates are less attractive compared to a US 10-year bond, close to 2.4%.

That is the main reason, not Donald Trump’s tweets, but of course the president-elect’s messages regarding NAFTA and his criticisms of automobile companies do not help.

Many analysts compare the current risk to that of 1994, shortly before the so-called “Tequila crisis,” which triggered a Mexican stock market crash and a domino effect on other emerging markets.

Why? The combination of capital outflows and rising current account deficit, which could lead to a huge liquidity crisis.

But, nevertheless, there are very important mitigating factors.

Although the outflow of capital is true, it is not at worrying levels. In addition, in 2016, Mexico was the third largest recipient of net capital , despite low oil prices and risks in emerging economies in an environment of low global growth and weaker international trade.

In addition, although foreign exchange reserves have declined since 2014, they remain at record highs and more than seven times above 1994 levels.

One of the distinguishing characteristics of this crisis compared to 1991 or 1994 is precisely that central banks of emerging economies have carried out a correct policy of preserving foreign currency reserves at the highest possible level, thus avoiding a liquidity crisis. Exactly the opposite of what these countires did in the 90s crises, where reserves were almost depleted trying to “defend” the currency.

In fact, the action of the central bank of Mexico in these days can be called more “technical” than the desperate ones of that time.

Another, and very important factor, is the exposure to leverage in the stock markets. Before the Tequila crisis, citizens and entities borrowed massively to buy a seemingly unstoppable bull stock market. The level of leverage in the stock market was such that there was a period when “margin debt” in terms of market size was higher than that of the US stock market in 2007.

If we analyze the perfect storm that happened in 2013-2015 in emerging countries, a dramatic crisis has been avoided despite the abrupt fall in commodities, net capital outflows and the global slowdown in trade (the “sudden stop” effect that we mentioned in 2013 here).

In this period, Mexico’s foreign currency revenue has been reduced by a third from the highs, and the fact that massive recession and crisis has been avoided proves that many things are very different today in Mexico.

These important differences must be taken into account when we read some alarmist messages, but we must also be cautious because the situation for emerging markets remains complex given the “hoover” effect of the US rate hike. A strong dollar, rising rates and inflation provoke a dollar-sucking effect out of riskier markets and back into the US domestic market. Especially after almost a decade of extraordinary capital flows into emerging markets.

Let us not forget the risks, the macroeconomic, political and monetary threats. The end of excess liquidity and cheap money is here and countries like Mexico will have to adapt to a level of investment and capital flows that will likely be much lower than those of the last eight years.

Mexico will have to take advantage of a year in which oil prices have stabilized to match its investments to a new reality, closer to that of 2000-2006 than the three US monetary stimulus programs. But if we have to look at risks, we also have to look at opportunities, because Mexico has always been a better option compared to other countries with greater risk.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Article published in elespanol.com in Spanish

Picture courtesy of Google Images