Our third-quarter outlook 2018

In this article we will review the third-quarter outlook for markets in the context of the global economy, protectionism and European politics.

The bias toward geopolitics is a testament to the additional uncertainties investors face today alongside the traditional volatility of economic cycles. In an industry perfectly at home analysing hard data, the rise of political influence and particularly ‘decree by tweet’ from a capricious US president is unsettling. Assumptions in the current environment are subsequently more prone to forecasting error which we must factor into our expected returns via a higher risk premium. This means that the discount to fair value for equities is increased and the more uncertain the politics, the higher the discount.

Mixed messages

The beginning of 2018 has been a mixed bag in terms of growth. We have seen Europe struggle to maintain the momentum of late 2017 while the trend in the US continues to be very positive. China has been steady but the tighter credit conditions put in place last year are beginning to dampen consumer demand.

We expect that the People’s Bank of China (PBOC) will ease policy in response to the weaker data and that further appreciation of the renminbi against benchmark currencies will halt. This will help to slow the deceleration of credit expansion, with the caveat that Beijing is committed to an improvement in credit quality and that any stimulus is likely to be incremental rather than material. In addition, the escalation of the provocative tit-for-tat trade strategy between China and the US is unsettling for investors. Although we believe a sensible compromise on trade will prevail, the potential for a negative surprise is an additional risk that investors now have to factor in.

The US economy continues to operate at near full utilisation and the Federal Reserve remains on track to increase interest rates twice more in 2018 and another two to three times in 2019.

The US economy continues to operate at near full utilisation and the Federal Reserve (Fed) remains on track to increase interest rates twice more in 2018 and another two to three times in 2019. Tax reform and the Bipartisan Budget Act appear to be working and the Fed is right to respond accordingly.

The backstop of the Fed ‘put’ may have been removed but the positive perspective for investors is that monetary policy remains unduly stimulative. The 10-year real interest rate is below 1% relative to a long-run average of 2.5% and broad money growth in the US also exceeds nominal GDP growth. Quantitative tightening by the Fed is effectively being offset by loan growth and the level of excess reserves in the banking system suggests that this has further to run. Unemployment is below the Fed’s target and consumer confidence is strong, with real wages rising around 1% and supporting higher retail sales. In the new isolationist world, the US economy is in good shape and the gradual approach by the Fed is not an immediate negative for risk.

Protectionism

Trade and protectionism obfuscate investor visibility but benefit President Trump ahead of the mid-term elections, particularly if he can deliver a deal with China and a win in North Korea. In a recent piece from TS Lombard Research, Charles Dumas also argues that the talks with Kim Jong-Un effectively diminished China’s role as a broker for the United States.

The direct US-North Korea diplomacy has effectively reduced China’s ability to leverage its influence over the rogue state in trade negotiations and improved the probability of an optimal result for the US. It is also a victory in the hegemony scoreboard for Trump at a time when America’s primacy is being challenged by Beijing.

China is likely to ease monetary policy to offset any negative economic impact of trade concessions.

China is likely to ease monetary policy to offset any negative economic impact of trade concessions, possibly via a modest depreciation of the renminbi and a reduction in the reserve ratio requirement for banks. China is constantly concerned that a weak currency will lead to capital flight but, on a labour-cost adjusted basis, the renminbi is overvalued and the contribution of real export growth to GDP has been negative for the past 18 months.

Therefore, the benefit of a lower RMB/USD rate probably outweighs the risks of capital flight at this juncture. China manages exchange rates against a basket of major currencies and the capital flight issue will be minimal if the RMB/USD is the only depreciating component of the currency basket.

Renminbi appreciation

A date with the ECB

The latest European Central Bank (ECB) meeting brought few surprises on the quantitative easing (QE) front with the announcement that they will taper purchases back to €15 billion per month in September and stop completely by year-end.

However, the ECB also took the unusual step of softening the QE message with a promise not to raise rates before the summer of 2019. This is new in the lexicon of Central bank messaging and was quite a surprise to investors. It is the first time a major Central bank has committed to a calendar timetable and it leaves the ECB vulnerable to the embarrassment of reversing policy if their conservative inflation target is exceeded.

This leaves the ECB vulnerable to the embarrassment of reversing policy if their conservative inflation target is exceeded.

A dovish handcuff is a positive for risk assets and should help stimulate European growth even further. Inflation will pick up via euro depreciation and the troublesome Italian economy will benefit from a weaker currency. For the ECB, a weaker currency is preferable to political upheaval.

However, a weak euro will undoubtedly provoke Donald Trump and his trade advisor, Peter Navarro, who are focused on the US current account deficit. It is likely that the tariff issue will shift onto a collision course with Europe and the huge (around US$70 billion) German trade surplus with the US in particular.

US trade imbalance with Germany

A complex route ahead

A positive prognosis of higher trade tariffs for European goods is that the impact would largely be felt in Germany rather than in the weaker states which have struggled with an over-valued euro. If tariffs were increased, investor money flows would also tend to migrate to the US rather than Europe, leading to stronger demand for US Treasuries.

Under this scenario, trade tariffs with Europe could lead to further euro depreciation and apply downward pressure on US interest rates at the same time. The Italian economy would probably go into recession if the euro appreciated, while tariffs mainly targeting German exports would leave Italy largely unaffected.

Targeting imbalances between the US and Europe (Germany) via tariffs may not necessarily be a bad outcome. Italy would benefit from a softer euro and US long-term interest rates would trade below fair value via an increase in net savings and investment.

There is already evidence of US dollars flowing back to the onshore economy as a result of the changes in corporate taxation and the scenario above would only accelerate this trend. Of the estimated US$2 trillion held offshore, a staggering US$650 billion was repatriated in the first half of this year. The subsequent dollar appreciation has effectively tightened monetary conditions in the US, leaving the Fed with less to do on the policy front.

Longer term, these capital flows will drive either stock repurchase programmes or capital expenditure and productivity. Productivity has been below the long-term trend in the US, as it has in the UK, and accelerated investment will raise the equilibrium growth rate. It will also moderate the trade imbalances even further over time. Therefore, the tactical use of tariffs and tax reform in the US is predominantly good for America in the medium term but also has structural long-term benefits for the global economy by reducing imbalances.

The tactical use of tariffs and tax reform in the US is predominantly good for America in the medium term but also has structural long-term benefits for the global economy.

Emerging markets (EM) which are dependent on offshore US dollar liquidity are likely to be the worst affected by any dollar flows onshore, and it will drive them to increase their dependence on China for liquidity. So far, the US dollar repatriation appears to be out of developed countries and tax havens, which implies that there is more pressure to come from tightening financial conditions if this expands to EM countries directly. However, we doubt that this scenario will transpire on any scale, on the basis that US companies still find EMs an attractive area for investment and long-term growth.

European exporters are also potential losers, but a weaker euro could ease the pain. Italy, as noted above, would certainly benefit from the currency depreciation, and it is likely that objections to a stimulative fiscal policy that breaks the EU Stability and Growth Pact would be vocal but ineffective. The political risks of intolerance of the stimulus are just too great a threat to the fundamentally flawed euro and the Italian economy will be stronger economically as a result.

Ultimately rewarding?

In summary, the noise around trade and politics is increasing market volatility but overall the net effect could be to extend the cycle by limiting the tightening of monetary policy.

The US will benefit most from the trade tactics, and concerns regarding Italy should fade. The internal imbalances in Europe should moderate and China will ease financial conditions, either via monetary policy or the currency versus the US dollar. The positive growth picture in emerging markets is already under threat from US dollar repatriation but we think the bulk of the easily accessed reserves have moved. If the repatriation damage does not abate, then China would need to react more aggressively with monetary policy or step in to provide liquidity fairly soon.

Overall, the conclusion is that trade tariffs add uncertainty to markets but the net effect should ultimately be a positive for equities – through easier financial conditions that extend the cycle.

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