The global economy is in the middle of a soft patch
With a number of recent key indicators showing slow growth in the global economy, some have speculated that we are heading for a recession. What therefore is the prospect of recession risk to financial markets in the coming months?
As a backdrop, the IMF recently lowered its 2019 global output growth expectations to 3.5%, its second downgrade in three months and the lowest rate for three years. Sluggish growth has been captured in some recent macro data releases reported in January. For instance, US pending home sales declined nearly 10% from a year ago, the biggest contraction in 5 years, French consumer confidence fell sharply following the yellow jacket (or gilet jaunes) demonstrations, and Chinese auto sales fell 5% in 2018, the first annual decline for 30 years. The partial shutdown of the US Federal government through most of the month, and the still unresolved trade spat between the US and China, adds another layer of uncertainty to the economic outlook.
Even so, January also saw some positive developments. First, the US announced its biggest increase in payrolls for nearly a year, with another increase in average hourly earnings, and a rise in the participation rate. This broadening and deepening in the labour market should put the economy on a solid foundation. Second, US personal spending has picked up, as evidenced by online shopping sales that rose over 20% from a year ago, during the important Christmas season. Third, the Chinese central bank announced additional monetary stimulus to complement tax cuts for both Mainland consumers and businesses this year. And fourth, Fed Chair Powell gave some dovish comments, to suggest the US central bank is flexible and prepared to adjust policy tightening if required.
On balance, it is our assessment the global economy is in the middle of a soft patch, rather than heading for a hard economic landing that could entail material risk for financial markets. Provided economic growth stabilises (our base case view), equities can rally from current attractive valuations and oversold positions.
Approaching Brexit crunch time
The UK is set to leave the EU on the 29 March 2019. However, following PM May’s heavy defeat over the “meaningful vote” on the governments withdrawal plan from the EU in the House of Commons in January, sterling appreciated against the US dollar, suggesting the foreign-exchange market believes the UK may not actually leave the single market at the end of March. And in what has been a pretty hectic month, the government survived a vote of no confidence tabled by the opposition Labour party, as Tory Brexiteers and the DUP, the government’s confidence and supply partner, gave their support to the embattled PM. The UK is in the bizarre situation where Tory backbenchers have confidence in the government, but no confidence in its flagship Brexit-policy.
In terms of market risks, Brexit-related scenarios can really be grouped into two broad buckets. The first bucket includes the less risky options for equities (at least initially), such as an orderly Brexit or no Brexit (either through revoking Article 50 or extending Article 50).
The second bucket includes the riskier options of no deal Brexit and a possible left-wing Jeremy Corbyn-led Labour government if a snap election were called. Indeed, based on current opinion polls, Electoral Calculus, a general election predictor, predicts 280 seats for Labour, 41 for the SNP and 291 for the Conservatives in the 650- seat House if an election were to be held now. Assuming the speaker and 3 deputies do not vote, and Sinn Fein do not take up their seats in the Commons, Labour could, with the help of the SNP, form an effective working majority with 321 seats in the House.
A no deal Brexit or snap election could lead to substantial UK capital outflows. To put this risk into some perspective, Bank of International Settlements data shows the EU has cross-border claims of nearly GBP1trn on the UK, while the UK has claims of GBP572bn on the EU. Should the UK’s relationship with the EU end in acrimony, under a no deal Brexit scenario, or Labour introduces higher tax rates under a new government, capital could leave the UK quite quickly. This could lead to sterling depreciation and a mark-down in UK financial asset prices.
With the clock running down, it is unclear how this deep political crisis in the UK will unfold. Both major political parties are split on which direction to go on Brexit. Though parliament is trying to wrestle with the government over how to use the available time in the House to agree a deal with the EU, the uncertainty created by Brexit is filtering through to sentiment and the real economy. For instance, with UK consumer confidence at its lowest level since mid-2013, retail sales volumes slumped in December. Given these political and economic risks, we believe that investors should be looking outside the UK for better equity
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.