The words of 2016 (part 3): Regime Change

This is the third post in a series of four devoted to key words which characterize 2016 from an economic and market perspective. Previous posts discussed ‘surprises’ and ‘disconnect’. This post covers ‘regime change’. It refers to entering a new era which implies that the future will be very different from the past and that the ways of doing business or investing will need to change. Quite likely there may be a period of prolonged uncertainty until it is clear what the new regime entails.

All this applies to Brexit, clearly the most binary and far-reaching case of regime change seen in 2016. The economic consequences have been very moderate thus far and the much-dreaded drag from increased uncertainty has not yet shown up in hard data for the UK economy to any sizeable degree. This is bound to change in 2017 as the negotiations with the European Union start and as uncertainty increasingly weighs on corporate investment and hiring. Moreover, increased inflation on the back of higher energy prices and the decline in sterling seen in 2016 will reduce household real spending power. In view of the important trade relationships, this will create spillover effects in the Eurozone. However, given the elections in several important Eurozone countries in 2017, commentators may very well focus on another possible spillover effect, which could also be called political contagion: to what extent will campaign topics reflect those in the UK in the run-up to the referendum and even those of the US presidential campaign? After the political surprises of last year, one would expect markets to be even more nervous about political uncertainty than they otherwise would have been.

The surprising outcome of the US campaign has brought us three other regime changes. A new president and administration by definition mean change, in particular on this occasion, considering the statements made by Donald Trump during the campaign on key economic and geopolitical topics and the appointments since becoming president-elect. To what extent and where exactly there will be a regime change will soon become clearer. Particular areas of importance on the economic front are international trade policy and fiscal policy. On the latter, markets have strongly played the theme of fiscal reflation and consumer confidence has also received a strong boost. Nevertheless, many questions remain: size and mix (tax cuts versus expenditure increases) of the stimulus, who will benefit from lower taxes (companies versus individuals), the size of the multiplier effect (less taxes means more spending means more income for others means more spending). The other is on monetary policy. Last month, with a 12 month interval, the Federal Reserve Open Market Committee (FOMC) has again hiked its key rate, bringing the total number of hikes in the current business cycle, which started in the summer of 2009, to … two. This gradualism if not slowness is bound to change, this year but in particular in 2018 when the consequences of fiscal stimulus in terms of growth and inflation should fully manifest themselves. After all, fiscal expansion in a full employment economy means faster wage growth and more inflation. Given the well-documented international spillover effects of US monetary policy (on bond yields, equity markets, currencies, corporate bond spreads), the importance of the new US policy mix is truly global.

In the Eurozone, the recent ECB decision to scale back as of April 2017 the monthly volume of asset purchases in conjunction with a 9 month extension shows it is way premature to talk about regime change. This looks more like a topic for 2018. However, there is a feeling of ‘change is in the air’. It is as if investors have already started preparing themselves for the post QE world which eventually will come. Gone are the days that the anticipation (in 2014) and the announcement (in January 2015) of ECB QE had a major impact on financial markets. Credit continues to grow but the pace is moderate. QE didn’t stop significant spread widening versus Bund yields during part of 2016 in Spain (difficulties of forming a new government) and Italy (concerns in the run-up to the referendum on constitutional reform) and in the final months of 2016 the euro only weakened against the dollar because of the changes happening in the US. With respect to fiscal policy, the European Commission has recommended a small expansion for the Eurozone as a whole but this is not enough to speak about regime change. The absence of a common fiscal policy means that the total is a simple sum of the parts and most ‘parts’ (countries) have no leeway at all whereas those which have (Germany in particular) do not see domestic reasons to reflate their economy. It remains to be seen whether the election outcome will bring about any change in this matter.