The Middle
The only free market leader in the world right now, bizarrely, is in Argentina of all places. Javier Milei, it's gonna be an interesting experiment. This is a highly, highly intelligent leader. ― Stanley Druckenmiller
Although most people still believe that Europe can be described as a more-or-less "free market system," it is hard to deny that the continent, especially the countries in the European Union, is moving towards a less market-based economic system with increasing regulations and subsidies to reallocate the factors of production.
Since the pandemic, this trend has intensified, as EU Commission President Ursula von der Leyen has made increasing efforts to centralize decision-making in Brussels, partly undermining national sovereignty. The European liberals (ALDE) inadvertently support this shift, as they envision the EU transforming into the United States of Europe. However, they have consistently failed to curb the regulatory excesses driven by the two major blocs within the Union: the conservatives and the social democrats.
Amidst these global tendencies, there is one country that has witnessed the full consequences of centralization and provides hope for free-market advocates aiming to counter the drift towards collectivist economic policies: Argentina. Once one of the wealthiest countries in the world, Argentina has experienced a dramatic economic decline due to interventionist economic policies, multiple state bankruptcies, and currency crises.
The public's frustration with politics led to the election of Javier Milei as president. Milei, who describes the state as a "criminal organization," has vowed to abolish the Argentinian central bank and used a chainsaw at his rallies to symbolize his intent to cut back the state. While these actions might shock many Europeans, they are the result of a populace that has realized increasing interventionism has worsened, not improved, their situation.
One can certainly criticize some of Milei's views, but his economic successes since taking office are evident. His radical program has already begun to transform the economy: inflation is falling, the currency is appreciating, the stock market is soaring, and the country has even posted a budget surplus. Although these changes come with high costs, such as economic turmoil from spending cuts, Milei's approval rating remains remarkably high, exceeding 50%.
Many European politicians can only dream of this level of support, yet the German-speaking media often frames Milei as a radical, insane, right-wing extremist. While his pace of reform is indeed radical, other aspects of his portrayal are exaggerated. Last week, Milei visited Germany to meet with Chancellor Scholz and to receive the "Hayek Medal" from the Friedrich August von Hayek Society.
State media described his visit as that of a difficult guest, "Die Zeit" suggested Milei was heading towards "market fascism," and "Die Welt" reported that Scholz urged Milei to ensure the social compatibility of his reforms. These reactions encapsulate the fear among German and broader Western policymakers and journalists (who are increasingly left-wing oriented) that Milei’s success could spark a shift in public opinion towards free-market policies, which have been condemned and demonized for decades.
While it remains to be seen whether Milei will ultimately succeed, his radical approach to domestic policy represents one of the most interesting economic experiments in the last 40 years. It has the potential to significantly impact the political and economic landscape worldwide, especially in Europe, where liberal views are only widespread among a small minority.
As we approach the summer, financial markets have shown very little change. Most stock indices are slightly up, while European and US bonds remain largely unchanged. Only Japanese 10-year bond futures have fallen by 0.56% since mid-month, essentially erasing the rally from the first half of the month.
The summer is always a very uneventful period, and without dramatic news, this year probably won't be any different. Hence, the "Weekly Wintersberger" will go on its usual summer break and will return sometime between the end of August and the beginning of September.
Last Friday, the latest Flash PMI numbers for Europe and the US were released, highlighting a reversal of the trend that started a while ago. In the spring, US data began to disappoint, while European data surprised on the upside. However, it now seems this was just a blip, and the trend has reversed again.
The Eurozone Manufacturing and Services PMIs came in below expectations, although the service sector remained slightly in expansion, albeit slower than anticipated (52.6 vs. the expected 53.4). Germany's manufacturing PMI again missed by a wide margin, coming in at 43.4 instead of the expected 46.4. In France, the disappointing results may be influenced by President Macron's decision to call general elections.
Overall, the Eurozone Composite PMI value of 50.8 (expected 52.5) suggests that the Eurozone is still expanding slightly, but the economy remains weak. Notably, the survey responses were only 85% of the usual response rate. The report also indicated ongoing struggles as new orders continued to fall, and this issue appears not only domestic but also international, with export orders decreasing sharply.
Employment expanded further, albeit at a slower pace than before, while the downturn in manufacturing led to a decline in purchasing activity, contributing to spare capacity in supply chains. In summary, the Eurozone economy is still holding up due to light service sector expansion. Still, the anticipated recovery in manufacturing appears to have stalled just as it seemed to be beginning.
Politically, the Eurozone cannot expect better conditions. Although the EU elections showed that many people are dissatisfied with the ruling parties, there is no reason to believe the political direction of the EU will change. Ursula von der Leyen is expected to be renominated for a second term. She and her party have finalized negotiations with the Social Democrats and the Liberal Party, resulting in top jobs for former Portuguese Prime Minister Antonio Costa as head of the European Council and Kaja Kallas as the EU's highest representative for foreign affairs.
While these appointments are not surprising, one might question Kallas's suitability, given her recent statement that the goal of the Ukraine-Russia war should be to break Russia into several pieces. European liberals, who seem increasingly neoconservative, might celebrate this view, but whether it is appropriate for a diplomat to speak this way is debatable.
Additionally, although von der Leyen and her party adopted a different tone during the election regarding the green transition, it wouldn't be surprising if they reverted to their previous stance now that the election is over and they have secured a win. Such flip-flopping is common in European politics.
Germany, Europe's largest economy, continues to struggle under its political leadership. Initially, there was hope that the liberal FDP could keep the Social Democrats and Greens in check and push for more business-friendly regulations. However, the FDP has proven to be a significant disappointment, failing to keep the German economy on track.
In 2024, Germany has seen a rise in bankruptcies to the highest level in almost ten years. While one could argue that the past decade had fewer bankruptcies due to factors like low interest rates, the acceleration in bankruptcies is worrying:
The dynamics of the insolvency situation have increased significantly again. While there was already an increase of 17.2 percent in 2023 as a whole, the rate of increase in the first six months of this year is almost 30 percent higher than in the same period last year. "The increase is not only continuing, it is even accelerating," describes Hantzsch.
Germany's energy policies remain costly. Partially due to the exit from Russian gas, Economic Minister Habeck has strongly subsidized the installation of renewable energy. This has led to higher expenditures for the finance ministry, which must balance the account under the "Renewable Energy Sources Act" (EEG):
So far, 9.8 billion euros of the available funds of 10.6 billion euros have been paid out. According to updated forecasts, 2.1 billion euros are needed just to pay out the monthly installment for July. This means that the funds in the EEG account are "already almost completely used up".
Everything points to continuously higher government spending in Europe, and this is not surprising. With a large social safety net, increasing defense expenditures, and efforts to increase subsidies to forcefully transition to a carbon-neutral economy, there seems to be no alternative to spending.
However, as governments don't need to worry about whether investments yield a profit, this can lead to resource wastage and capital misallocations. Europe's answer to every problem seems stuck in the low-interest-rate era. While the acceleration of becoming like Argentina is still a bit extreme, it is becoming more probable.
Despite these issues, European financial markets have remained relatively unaffected, which I attribute mainly to the US's continued economic strength. Although the artificially induced boom during the COVID era is ending and growth is slowing, the US economy remains robust.
The US Flash PMI, published last Friday, underscores this strength. Output growth hit a 26-month high while price pressures continued to diminish – a goldilocks scenario for the US economy. Businesses remain optimistic about the future, employment is improving, and manufacturing is also on the rise.
The US economy, with its robust consumer spending, continues to support the global economy. However, navigating this is challenging because people's actions often differ from what they report in surveys. For instance, while some surveys suggested Americans planned to cut back on travel, TSA recorded record-breaking travel volumes over the Independence Day weekend.
We're living in a strange economy where some indicators suggest an imminent recession while other data contradicts this. After considering it for some time, I believe this situation results from the COVID response and the unprecedented government and central bank spending and printing spree.
The inflation we witnessed was one consequence of this, but another is that the money is still circulating through the economy without continuing to push prices up. It shifted supply and demand curves across the economy, leading to different resource allocations than we would have seen without the stimulus and printing.
As the money continues to spread through the economy, the rise in interest rates has had less impact than most expected. It not only reduced demand for homes but also choked off supply as people stopped putting homes on the market and postponed buying plans. Despite these issues, the US housing market remains functional, partly due to significant US government construction spending, which has helped keep the building sector stable.
Another problem caused by rapidly rising interest rates was the pressure on banks due to the drop in the value of their assets. However, since the US banking crisis last year, the Federal Reserve's financial measures to keep the system afloat seem to have paid off. On the surface, the banking sector is in good shape, with rising earnings and stock prices.
Under these circumstances, it's logical to assume (like the Fed) that the banking sector is in good shape, right? However, Christopher Whalen from the "Institutional Risk Analyst" isn't that optimistic. He estimates that the Fed's monetary policy has resulted in a capital deficit of $1.3 trillion as of Q1 2024.
As long as this remains below the surface, markets won't be worried about it. Honestly, I don't expect it to become an issue until the real economic numbers show further deterioration. The Fed is acting wisely to keep the system afloat at the moment, but each intervention creates additional problems that require even further intervention.
On the other hand, economic strength is exposing shifts in consumption patterns from expensive to cheaper versions of products. The food and grocery industry seems particularly affected. General Mills is a prime example:
General Mills shares plunged nearly 8% at the start of the US cash session, marking its steepest intra-day drop since May 2022. The decline followed the packaged-food company's report of fourth-quarter sales that missed average analyst estimates, coupled with a full-year sales forecast that also fell short. This disappointing outlook signals more evidence of a consumer pullback amid elevated food prices and builds on our weak consumer theme.
In conclusion, troubles for the most vulnerable consumers are intensifying. However, this doesn't indicate that a recession is imminent. To assess that, we need further evidence supporting the bear case. So far, I think there's too little.
In hindsight, the US might discover it has already been in a recession, but for financial markets, this doesn't matter. As long as the majority of market participants don't support the bear case, staying bearish and going short will only deplete one's capital.
If one's assessment of the economy's future path is bearish, one can still turn to treasury bills to receive a good yield, probably not as high as remaining long in the indices, but still 5% (in the US). At worst, I think the stock market will continue to fluctuate around the current highs, so having some longs might still pay off.
The situation regarding the bond market remains extremely complicated. As inflation comes down, the market increasingly calls for rate cuts, but as long as the labor market and the economy remain solid, investors might continue to burn their hands by going long bonds.
My assessment last week, namely that the fast-shifting optimism of many bond investors suggests they're currently running into a big bull trap, hasn't fully played out. However, several attempts by bulls to push bonds higher since mid-June haven't come to fruition.
I've studied the dynamics of the yield curve more this week, and I conclude that the long bond still doesn't offer an attractive entry point. Even as inflation trends go down, monthly CPI numbers can fluctuate around that trend due to sentiment and a dynamic economy. Unlike in economic theory, prices are rarely in equilibrium because of the economy's constant flux.
Therefore, incorrect expectations and assessments from actors can lead to higher monthly CPI rates that later turn out to be unsustainable. However, the market will not remain calm if it is surprised by an unexpected upward movement. Needless to say, a stronger-than-expected drop in inflation will also fuel hopes for sooner and more rate cuts.
The crucial point here is whether the Fed will cut rates if inflation drops faster than anticipated. As long as the economy remains similar or slightly weaker than now, I don't believe the Fed will feel the need to cut. It's more likely, in my opinion, that Powell will find reasons to keep rates high for as long as possible. The only scenario for sooner and deeper cuts, in my view, is if a recession hits, but that's not on the horizon so far.
Are long-term bonds attractive if there's no deep recession? After all, the yield curve is still deeply inverted, with short-term interest rates signaling no cuts and long-term yields remaining below the Fed Funds rate. Market participants seem to think that the long bond is still a good investment because they speculate on a drastic drop in interest rates.
It's worth looking at the last soft landing the Fed achieved in the mid-1990s. During that period, the Fed only cut rates slightly, but the reaction of long-term yields was the opposite. They dropped from late 1994 onwards as markets anticipated a rate cut. However, as the rate cuts remained modest, investors' expectations adjusted, leading them to demand a higher 10-year yield, which rose by more than 100 basis points to accurately reflect duration risk.
From 1970 to today, the average spread between the effective Fed Funds rate and the US 10-year yield has been 108 basis points. This suggests that using the average spread, the US 10-year yield would be around 6.4% at the moment. However, as seen in the chart below, the spread widens when rates are cut and narrow when they rise.
Currently, the 10-year yield is so far below the Fed Funds rate that I wouldn't expect it to fall drastically if the Fed cuts rates by 25 basis points this year. If we assume the Fed suddenly decides to cut rates to 3% this year, which would mean a total of nine rate cuts, the US 10-year yield should remain around current levels if the spread approaches its historical averages.
Hence, small rate cuts offer little downside for long-term yields. If markets don't believe more than one cut is coming, then the 10-year yield should rise because investors will start to demand a higher yield due to duration risk, leading to an increase in long-term yields. The only scenario where long-term bonds would significantly rise would be a deep recession, in which case the short end also offers good opportunities with less downside risk.
At the moment, I'm not convinced that the summer will bring significant changes to the current financial market environment and asset price trends. After the summer break, things might change. For now, we remain in the middle!
It just takes some time
Little girl, you're in the middle of the ride
Everything, everything'll be just fine
Everything, everything'll be alright, alrightJimmy Eat World - The Middle
Have a great Summer!
Fabian Wintersberger
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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.