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Rothschild February Monthly Letter

While the Eurozone economy ended the year on a positive note by recording a 0.5% increase in its GDP, growth for 2016 as a whole will have been 1.7%, a slight deceleration compared to 1.9% in 2015. The unemployment rate has nonetheless continued its decline, reaching a low point since May 2009. The Markit composite index, as well as the confidence index published by the European Commission, point to buoyant economic activity in the 1st quarter of 2017. That said, the positive effects of the fall in oil prices in the first half of last year could falter and then reverse as prices have been increasing. For its part, the political calendar remains busy. In France, the Francois Fillon scandal adds uncertainty to the results of the April/May presidential elections. In Italy, the Constitutional Court has validated much of the mechanism of the electoral law "Italicum" designed by the government of the former Prime Minister Matteo Renzi. Although the majority premium of 55% of the seats in the Chamber of Deputies was accepted, the Court rejected the principle of a second round, provided that no party would reach 40% in the first round. Therefore, the likelihood that the 5 Star Movement can enjoy a majority in the Chamber is very limited. However, the next election might not usher in a strong, responsible government, but yet more political instability, which Italy can ill afford. The spread between Germany and Italy has thus returned to its highest since 2014, which should prompt the ECB (European Central Bank) to exercise utmost caution and patience.

In the United Kingdom, Prime Minister Theresa May outlined her priorities, stressing that she hoped to enter into a trade agreement with the European Union but reiterated that no deal for Britain is better than a bad deal for Britain. While growth was robust (+ 0.6%) at the end of the year, there is little doubt that economic activity was supported in large part by a combination of rather temporary factors: generous fiscal measures and easing monetary policy initiated as early as last July by the Bank of England. The British economy is unlikely to be able to maintain this pace, not only because the depreciation of the pound will reduce the purchasing power of households, but also because the period of uncertainty that is opening up with the triggering of Article 50 of the Treaty of Lisbon scheduled for next March could lead to curbing investment decisions of corporates and households. What’s more, the pound’s sharp fall might ultimately hurt almost as many exporters as it has aided. Many smaller businesses billed overseas customers in domestic currency but paid for some of their raw materials in foreign currency, which leaves those companies exposed to the costs associated with the declining pound.

In the United States, growth in the 4th quarter will have been 0.5% (1.9% on an annualized basis), which is not a reflection of an overheating economy. More generally, growth reached 1.6% in 2016, the lowest since 2011. The outlook for 2017 is brighter according to business and household confidence indexes. Yet, this improvement is partly due to high expectations of a significant reduction in tax rates and a tax reform that would greatly benefit businesses. If President Trump is unable to deliver on his promises, business sentiment could relapse. For the time being, the new president has been more active in sending signals about the adoption of protectionist measures rather than implementing the much awaited tax program, on which visibility remains very limited. While job creation remains dynamic, the U6 unemployment rate – which includes discouraged workers and all other marginally attached workers – nevertheless reached 9.4% in January, the highest since last October. Unused capacity in the labor market thus seems to be still present. In fact, hourly wages grew only 2.5% year-on-year and the employment cost index – a more comprehensive measure of wage costs as it also includes benefits – was up only 2.2% in the 4th quarter. For the Fed, these statistics should give weight to members of the monetary committee who advocate a very gradual approach to the normalization of monetary policy. In this sense, an increase in interest rates at the next meeting on March 15 is unlikely, in our opinion. That said, the Fed is still waiting for more details about the stimulus program from President Trump before re-calibrating its monetary policy outlook.

In China, the authorities have probably concluded that the measures put in place to support growth have reached their limits. The formation of bubbles in the housing market in several regions and, more generally, the continuation of the rise in credit growth are indeed important risks for the Chinese financial system. It is in this context that several local governments have put in place restrictions to curb rising housing prices. Moreover, the central bank surprised the market by announcing in early February an increase in short-term interest rates in order to mark its desire to better control credit growth, but also to try to slow capital outflows which reached a record $725 billion in 2016, compared to $675 billion in 2015 and $160 billion in 2014. It remains to be seen whether President Trump will carry out his threat of formally accusing China of manipulating its currency while ironically the authorities aim more to support the yuan than to depreciate it.



CRN: 2017-0201-5782 R

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.