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Kristina Hooper | July 18, 2017

Market review: The global forces of disruption

One of the key themes I’ve identified for 2017 and beyond is global disruption. Disruption can take many forms and be either a positive or negative force. The economist Joseph Schumpeter argued that disruption could be a positive force for economies – hence the term, “creative destruction.” Disruption – both positive and negative, both geopolitical and monetary – is abundant across the globe right now.

Changes afoot in France

Let’s start with France. The disruption in France is political in nature, but I view it as positive force. A new leader from a political party he created a short time ago is attempting to turn France into a business-friendly country. President Emmanuel Macron has already surprised skeptics in the past year; his newborn political party won a decisive majority in Parliament in June and he is now moving forward with a pro-growth, reform-focused agenda. The focus of his efforts is labour reform, which makes sense given France’s relatively high unemployment level.

For example, the eurozone’s largest economy, Germany, currently has an unemployment rate of 3.9%, while France, the second-largest economy in the eurozone, endures a much higher unemployment rate of 10%.1 Corporate leaders have been known to explain this phenomenon by sharing anecdotes of how difficult it is to employ people in France because of the heavy regulations imposed on employers. Many would rather avoid hiring additional employees than make a decision they can’t reverse in the future. As a result of this philosophy, arguably many able-bodied workers go unemployed.

President Macron intends to change that by making it easier for employers in France – decentralizing collective bargaining to an individual company level to allow for more flexibility, with the goal of making France more competitive with Germany and some Scandinavian countries. Macron would also like to limit severance pay and reduce the corporate tax from its current rate of 34% to 25% within five years – again with the goal of making France more competitive. In addition, Macron plans to reduce the public deficit this year to the 3% of gross domestic product (GDP) target set by the European Union (EU). Next year, he plans to cut some individual taxes, including the wealth tax. Granted, these proposed tax cuts will not be easy given that France’s debt-to-GDP level is relatively high, making it difficult to reduce revenue at a time when the government needs every euro it can get. Nonetheless, Macron seems willing to have the government take a short-term hit in revenue in order to achieve longer-term growth objectives.

Macron’s pro-growth focus has buoyed sentiment in a way similar to what occurred in the U.S. post-election, when business and consumer sentiment was boosted. Both the INSEE France Business Confidence Index and the France Manufacturing Purchasing Managers’ Index are on the rise. Consumer sentiment is even more positive, with the INSEE France Consumer Confidence Index reaching a 10-year high. Now, as we’ve seen in the U.S., sentiment doesn’t always translate into economic activity – at least not immediately. But keep in mind that the party Macron founded has won a majority in Parliament and his cabinet has approved a number of significant changes to the labour code, which should help Macron achieve his objectives. Given these catalysts, it seems possible that his agenda will come to fruition. What’s more, Macron would like to reform the EU. If Macron successfully enacts reforms in France, he may very well be able to do the same for the EU, which could result in even more upside over the medium term.

Brexit looms over United Kingdom

In the United Kingdom (U.K.), political disruption is also alive and well. Here, though, disruption takes a more negative form, in my view, as the country attempts to navigate uncharted waters after its proposed divorce from the EU. There is a great deal of uncertainty over what Brexit will look like, which presents the greatest downside risk to the U.K.’s economic outlook. Business leaders have expressed their frustration with Prime Minister Theresa May’s rigid approach to the U.K.’s separation from the EU, and it seems the prime minister’s cabinet is at odds over whether or not the U.K. should have a hard Brexit. To complicate matters, momentum is growing for a second referendum to be held on whether the U.K. should exit the EU, although such a vote seems very unlikely.

Although many fear what a hard Brexit may do to the U.K.’s economy, hope for a more flexible approach came in the form of comments last week from former Prime Minister Tony Blair, who is desperately trying to find a compromise that would enable Britain to remain in the single market. Blair proposes a compromise that addresses British concerns about immigration, but which enables continued free trade. It remains to be seen whether Blair can alter the course of Brexit negotiations, but it could be a real positive for the U.K. economy if he can even help orchestrate a softer Brexit. While anything but a hard Brexit seems unlikely at this juncture, there is still a small possibility that the U.K. can pursue a different scenario.

Political disruption roils South America

There is also disruption in South America, which is very much of a political nature. In Brazil last week, former President Luiz Inacio Lula da Silva was sentenced to nearly 10 years in prison, which adds to the country’s instability. His successor, Dilma Rousseff, was also convicted while serving as president, and the current president, Michel Temer, faces corruption charges as well. Lula’s sentencing complicates the current political landscape, as he was a frontrunner to lead the country in next year’s election. The good news is that Brazil seems somewhat immune to such political instability. While still in contraction, Brazil’s GDP growth in the first quarter was higher than it has been in about two years.

What’s going on in Brazil pales in comparison to recent events in Venezuela. Venezuela’s legislature has been the object of violence in recent weeks. Sadly, yesterday saw unofficial referendum voting – called by the opposition to demonstrate a rejection of President Nicolás Maduro’s proposed constitutional changes – turn bloody, as gunmen shot at voters, killing one woman. Venezuela has been in a state of crisis for years, but in the last several months we have seen an escalation of violence. It seems this country will either move toward fewer freedoms and greater scarcity of goods and commerce – which seems likely – or it will experience a revolution, which may or may not result in better leadership.

Financial reforms in China

In China, it seems disruption will be coming soon, albeit of a financial nature. China had its National Finance Work Conference last week, which is held every five years and has historically affected the financial industry. President Xi Jinping expressed his desire to see more regulation and reform for the financial industry. As a result, we are likely to see significant deleveraging going forward, particularly among state-owned enterprises, which have seen their debt levels grow in the last decade. Financial reform should be positive for the Chinese economy in the medium to longer term, but in the short term could provide a slight headwind. Regardless, the Chinese government is likely to take a gradual, measured approach, which should reduce overall disruption.

Potential monetary disruption in North America

Finally, we’re seeing the potential for monetary policy disruption in North America. The Bank of Canada (BoC) made monetary policy history last week by raising interest rates for the first time in roughly seven years. A rate hike was not expected more than a month ago, but was well-telegraphed within the last month and quickly became expected in advance of the announcement. This decision is a double-edged sword. It should be viewed as a vote of confidence in the Canadian economy, which posted strong growth in the first half of the year. However, higher rates could create headwinds to the Canadian economy in the second half of the year. This comes at a time when Canada is facing housing issues that are short-term in nature, but which can adversely affect economic growth by tamping down residential investment, and even consumer spending in general. (An economic theory known as the “wealth effect” suggests that consumers spend more when they perceive their net worth to be higher, and that net worth is derived primarily from the value of their investment portfolios and the value of the real estate they own.)

While the BoC does not appear to be racing ahead with further tightening, some are concerned that the BoC may get “ahead of the curve” by raising rates at the very time that the housing market needs support from lower rates. This offers the possibility for disruption that could have negative consequences ­– at least in the short term.

In the United States, Federal Reserve (Fed) Chair Janet Yellen testified before Congress about the Fed’s plans for monetary policy normalization. Yellen shared her expectation that balance sheet normalization will begin “relatively soon,” but soothed concerns that the Fed will quicken its pace of tightening, admitting that there are downside risks to the Fed’s inflation projections. In addition, she suggested that the current fed funds rate is not far from the neutral rate. U.S. stocks rose in response to her comments – a reaction that is something of a head scratcher. After all, Yellen is likely a lame duck Fed chair, given rumors that Gary Cohn, currently Chair of the Council of Economic Advisors, will soon be nominated to serve as the next Fed Chair. In addition, there are several open seats on the Federal Open Markets Committee (one nominee was named last week), which means the composition of the Fed could tilt more hawkish – making Yellen’s testimony last week virtually moot. Delicacy is needed with the unwinding of monetary policy, but this approach may not continue if there is a regime change at the Fed. This creates the potential for monetary policy disruption.

Looking ahead

Looking ahead, this will be a relatively quiet week. Most important will be the European Central Bank (ECB) and Bank of Japan meetings later this week. It is unlikely that there will be any surprises, but we will want to pay close attention to any tweaking of language – particularly from the ECB, which is being watched closely for signs of possible monetary tightening.

These days, disruption seems commonplace in economies around the world, and with it comes the potential for heightened volatility in capital markets. As we analyze disruptions and their potential impacts, we need to remember that disruption can create both risks and opportunities for investors. This means investors should emphasize downside protection and selectivity in their portfolio construction.

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1 Source: Organization for Economic Cooperation and Development

The France Business Confidence Index is calculated by INSEE and measures the level of optimism that business executives in industrial and commercial sectors have about the performance of the French economy and how they feel about their organizations’ prospects.

The French Manufacturing Purchasing Manager’s Index measures the activity level of purchasing managers in the manufacturing sector.

The France Consumer Confidence Index measures cyclical trends as perceived by households, and contributes to the evaluation of the French economic outlook.

The opinions referenced above are those of Kristina Hooper as of July 17, 2017. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

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