I told you last week that I was working on my Europe forecast for 2017, and - as it turns out - it's not a very rosy one.
The truth is, we may be much closer to the end of the current form of the European Union than most people - and markets - assume.
Investors treated Brexit and rejection of the Italian constitutional referendum as reasons to rally in 2016, a reaction I did not expect and believe is misguided (perhaps the negative reaction will be delayed until later in 2017). The current structure of the European Union and the monetary policies of the European Central Bank (ECB) are anti-growth. The ECB is pursuing the same policies that failed to stimulate sustainable economic growth in the United States and Japan - ZIRP and QE. Rising economic and political pressures may hasten a new governance model in which individual nations could regain control of their own economies and currencies, but such a process will engender serious economic and market instability.
With important elections on the horizon in Germany, France and Italy, the future of the European Union may be rewritten by voters before the end of 2017.
As I've been explaining for a long time, that instability will create ripple effects that are felt round the world.
And it could start a lot sooner than we think.
My Europe Outlook for 2017 And Beyond
The European bond markets, along with global bond markets, are already casting their votes and suffering losses that are only small down payments on the epic central bank-induced bond market bubble that is starting to unwind. January was the worst month for European bonds in years. The recent decision by the ECB to extend its QE program by 9 months to the end of 2017 but to reduce monthly bond repurchases by €20 billion is likely a last bite at a rotten apple. Or at least we can hope so.
Particularly toxic are long-dated investment grade European and Japanese sovereign and corporate bonds that face both rising interest rates and a weakening currency. Unfortunately, shorting these securities, one of the most compelling trades in today's market, is difficult outside the derivatives markets. Investors can short international bonds through the Vanguard Total Return International Bond ETF (NASDAQ:BNDX) or European banks via iShares MSCI European Financials ETF (NASDAQ:EUFN). Wide swathes of the European banking system remain in distress (such as the insolvent Italian banking system, several UK banks, and serial lawbreaker Deutsche Bank).
To be clear, European monetary policy consisting of negative interest rates, QE and massive jawboning by Mario Draghi produced very little in the way of sustainable economic growth. The cost is billions of euros of negative yielding bonds certain to produce massive losses for investors lured into buying them, the erosion of the capital of European insurance companies and banks, and the devastation of European bond market liquidity. These unintended but entirely foreseeable consequences are the result of leaving monetary policy in the hands of bureaucrats and academics with no skin in the game other than their own high opinions of themselves and analysis of their actions in the hands of a complicit, agenda-driven and economically illiterate financial press.
The fact that Europe's current governance structure renders pro-growth fiscal policy impossible to achieve doesn't change the fact that the monetary policy regime of trying to solve a debt crisis with more debt is doomed to failure. The question is how long inertia and political paralysis will be able to keep this region from another crisis. The answer depends on how much longer people choose to believe in the phony omnipotence of central bankers. It would not be surprising to see this regime rejected in the upcoming elections in Germany, France and Italy.
Investors are also looking at how the U.K. handles Brexit. A long and tortured process will hurt British and European growth while an efficient and prompt exit should spare the region. But the UK may be only the tip of the iceberg in terms of the European Union coming apart. In France, a scandal appears to be sinking the chances of Francois Fillon, a fiscal conservative, succeeding the feckless Francois Hollande as president. This opens the door to far-right candidate Marie Le Pen. In Germany, Chancellor Angela Merkel is facing a tough re-election battle as she struggles to defend her immigration policies (which suffered a tragic blow with the Christmas market attack in Berlin by a man on multiple terrorist watch lists).
Europe remains a potential source of serious economic and market instability in 2017 and beyond until it gets its political house in order, something unlikely to happen quietly. In fact, a much more likely scenario is a disruptive end of the European Union within the next five years.
My Forecasts for Individual Countries and Currencies
The US Dollar Index (DXY) ended January at 99.55, down sharply from its post-election high of 103.82. It lost half of its post-election gains after President Trump told The Wall Street Journal a couple of weeks ago that the dollar was "too strong," raising questions whether the new administration will try to weaken the currency in order to aid American exports. Clearly a strong dollar, like higher interest rates, creates a headwind to the higher growth that the Trump administration promises. Unlike previous presidents, Mr. Trump has no compunction about trashing his own currency, something that is going to take markets some getting used to. While I continue to believe that investors should maintain short Euro and Yen positions against the US Dollar (for instance, buying puts on the iShares MSCI Europe Financials ETF [NASDAQ:EUFN]), I would proceed cautiously because Mr. Trump could tweet a monkey wrench into this trade at any time. (If he does indeed succeed in weakening the dollar, my stock recommendations are here.)
At the end of the day, Europe and Japan still need to weaken their currencies in order to boost economic growth and inflation; whether they can achieve this at the end of an epic money-printing orgy remains to be seen. Europe is showing slightly better growth (though 0.5% GDP growth in 4Q16 hardly seems anything to write home about) but continues to face crippling structural and political obstacles to economic recovery. Greece is once again teetering on the brink of default and should be allowed to exit before it crumbles into the dust of the Acropolis. The odds of the European Union maintaining its current form are diminishing.
Japan remains terminal. The Bank of Japan completed its most recent two-day meeting by keeping the cost of money at a ridiculous -0.1%. It slightly increased its growth forecasts to +1.4% from +1.0% in fiscal 2016, +1.5% to +1.3% in fiscal 2017 and 1.1% from 0.9% in fiscal 2018 (I will believe it when I see it) and expects core CPI in 2017 to be +1.5% (ditto). Naturally, it extended its lending support program for another year and said it will continue nationalizing its equity markets at a rate of JPY6 trillion in ETFs and JPY90 billion in Japanese REITS per year. Japan continues to follow policies that insure that its slow- motion economic fade continues. Many investors believe that the Japanese stock market may be the best place for hunt for returns in 2017 due to efforts to weaken the Yen and spur exports. I would place that bet in the category of "in the realm of the blind, the one-eyed man is king." Japan may be the best house in an extremely overvalued neighborhood but that's about it.
China remains an economic house of cards on the verge of a debt crisis. Its Communist rulers may be able to delay the day of reckoning, but they do not have the power to repeal the laws of economics. The Chines Yuan will continue to weaken as authorities try to deal with an epic debt bubble and massive overcapacity throughout the economy. But it may also suffer from a new set of challenges as President Trump appears to want to challenge Chinese hegemony in the South China Sea and over Taiwan. In the end, currencies are reflections of both economic and political power. If Mr. Trump can expose China's weaknesses, the Yuan could come under more serious pressure (which ironically could hurt Mr. Trump's efforts on trade).
Gold recovered some of the ground it lost after the election with the spot price ending January at over $1,200.50/oz. Anyone who believes that central banks are finished destroying the value of paper money is ignoring history as well as the fact that currency debauchment is going to be the main method governments employ to repay (or at least reduce) debt. In the current global environment, where there is more than $200 trillion of global debt and $50-60 trillion of that resides in the United States alone (excluding unfunded future promises of hundreds of trillions of dollars), debasement of the US dollar is a certainty. Investors should continue to accumulate gold and save themselves.
About the Author
Prominent money manager. Has built top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.