First it was Brexit. Market players were sure the feisty Brits wouldn’t actually follow through with their threats to leave the European Union. Even in the face of polls indicating a much tighter race, the market continued pricing in a BREMAIN win until the facts could no longer be denied.
Then came Trump. Again the market was confident Hillary would prevail. When the opposite occurred, the markets reacted with panic as almost no one had given Trump a realistic chance.
We are all familiar with the ancient Italian proverb about fooling me once and then twice, but most of us are unaware of Stephen King’s adaptation:
“Fool me once, shame on you. Fool me twice, shame on me. Fool me three times, shame on both of us.”
After underestimating the potential for populist wins, the market is now determined to not make the same mistake a third time.
And it makes sense. What is the bigger risk for a money manager? Hedging against another populist “surprise” win, or once again assuming the electorate will not take that road? The answer is obvious. Failing to hedge against another populist win is the fireable offense. No one will criticize a prudent cutting of this risk. On the other side of the spectrum, no money manager wants the embarrassment of being caught on the wrong side of another populist development for a third time.
This phenomenon is why France’s Marie Le Pen’s recent popularity uptick has caused so much worry in European financial markets.
With every report of France’s far-right leader’s rise, investors have fled French financial assets, taking a shoot first, ask questions later approach.
This is best exemplified by the recent widening out of French / German yield spreads. Investors are worried Le Pen will win, and might in fact follow through with her plan to leave the EU.
This flight out of French (and other European risky assets) is creating a wall of money flowing into German (supposedly safe) assets. This morning, the German 2 year yield hit a record low of minus 86 basis points! F’ me.
An investor needs to give up more than a 1.5% of their principal for the privilege of lending the German government money for two years.
Although the market is now determined to get out ahead of the French populist risk, what if investors are now making a mistake in the other direction?
Yeah, I get it. Le Pen is scary. She wants to exit the European Union. If she wins, it will make BREXIT and Trump look like minor political changes.
But we are still months away from a French election. In the meantime, the European economy is screaming.
This morning’s EU PMI figures tell the story.
After languishing between 52 and 54 for the past couple of years, it has finally broken out with a huge upside surprise.
And this should correspond to growth in the coming quarters. This morning my fellow countryman turned American, George Pearkes from Bespoke, published this great chart:
Last week Trump chastised Europe for having a currency that was too low. You know what? He’s right. Investors are busy dumping Euros because of their Trump infatuation and Le Pen fear. But that’s only lowering the currency and helping boost the European economy.
The European economy has a monstrous amount of stimulus being applied to it. The weak currency and Draghi’s massive quantitative easing program (and let’s not forget the TLTROs) is goosing Europe, yet German 2 year yields are trading at all time record lows!
I am not sure when the pressure valve will be released, but this cannot continue for long. It is one thing to have record negative yields when the economy is stuttering, but this is the exact opposite situation. Rarely does fixed income diverge so dramatically from the economy.
This will correct with a massive repricing of German fixed income lower. Investors are busy chasing the “supposed” safe asset to make sure they don’t get burned for a third time. Once again, they will most likely be set up with the wrong position. At this rate, the ECB will be forced to taper way sooner than the market realizes, regardless of the political risk.
Inflation is quickly approaching Draghi’s target. Don’t look now, but 2% will be hit sooner rather than later.
I continue to love owning European stocks versus American ones, while also being short bunds versus long US fixed income. Today’s economic numbers out of Europe only embolden me, but then again, I am the sort of idiot Stephen King was warning about…
Thanks for reading,