Summer is normally a time to slow the pulse rate and relax, unless of course you have energetic youngsters, enjoy near death experiences like wing-suiting or invest in bonds and equities.
Off or on?
Equity volatility, as measured by the VIX index spiked to 25 in August compared to a 5-year average of 15. For the most part, the credit once again goes to President Trump who managed to both initiate and defer trade tariffs on China within the space of 15 days – surely a record for flip-flopping on a grand scale. The collateral damage has been to both investor confidence and investment intentions around the world, and it is no surprise that capital investment is drying up and business expectations are deteriorating.
To be fair to Donald, the month had a bad start. This was thanks to some very poor communication by his nemesis, Jerome Powell of the Federal Reserve (Fed), who turned a dream scenario into a nightmare at a press conference post the 31 July meeting. Powell spooked markets by replacing “data dependence” with an explicit statement that “this [cut] was not the beginning of a long series of rate cuts”.
President Trump compounded the Powell faux pas on 1 August with the untimely introduction of a 10% tariff on an additional £300 billion of imports from China and the US stock market duly fell 4% over the following 3 days. 10-year bond yields dropped from 2.02% to 1.70% in the same timeframe and, after a short respite, fell further to a closing low of 1.53% on 15 August before Trump announced the delay in the implementation of tariffs until December in order to save Christmas. Over the same 14 days, the MSCI UK fell 6.1%, the MSCI World fell by 4.7% and the UK 10-year gilt yield fell 20 bps to 0.41%.
Bond yields reflect uncertainty
The US/Sino relationship deteriorated further on 5 August when China halted any further purchases of US agricultural goods and allowed the upper end of the yuan trading band to go above 7 yuan per US dollar. Trump promptly labelled China a currency manipulator while simultaneously blaming the Fed for not doing enough to weaken the dollar.
The move lower in the yuan unsettled markets, but Gerard Minack at Minack Advisors suggests that China is more likely to pursue a managed depreciation strategy rather than the more violent devaluation we witnessed in 2015. Minack also believes that the currencies of the peripheral Asian nations may come under pressure but the external positions or current account balances are better positioned than ever to absorb the adjustment.
Nonetheless, Barclays research reminded us back in June of just how dangerous this face-off between China and the US could be. They suggested that the Goldilocks world of low rates and low inflation was in danger of falling victim to a “Thucydides Trap”, a condition in which a great power and a rising challenger misunderstand intentions to the point of war; whether it be economic or military.
Investors have also been digesting lacklustre growth in second-quarter corporate earnings in the midst of this mid-summer macro volatility, plus the relatively rare spectre of a yield curve inversion in both the UK and the US.
Does the yield curve inversion matter?
A yield curve inversion has historically been a very reliable indicator of recession with an average interval of 17 months from the inversion to the beginning of the recession. However, given that most recessions are caused by a Central bank raising interest rates to stop an economy overheating, the relationship is inevitability cause and effect. Never before has an inversion been preceded by the magnitude of decline in short rates that we have seen on this occasion. That said, I have been doing this for 30 years and quite a lot of what’s happening is a new experience, so never say never!
Historically, an inversion signal should persist for over a month and bank credit needs to tighten for it to have any predictive power. On this occasion, the US yield curve only inverted intraday and bank credit shows no signs of slowing. One reason for solid credit growth may be that, in contrast to previous inversions, US banks now receive interest rather than pay interest on the US$1.4 trillion in commercial bank reserves at the Fed. Therefore, liquidity is being maintained and lending continues at a healthy pace. With this in mind, we believe that the probability of a US recession in 2020 remains quite small.
What an inversion means for US equities is debateable, since other material factors, aside from interest rates, are in play. Charles Gave at Gavekal notes that while the discount rate for markets has stayed low, “the big downward revision in US profits [over the past 4 months] has cut the projected value of the US equity market significantly”. With the caveat that Charles is a bit of a broken record on the overvaluation of US equities, his model suggests that “the S&P 500 is now overvalued by around 55% versus a mere 30% before.” Therefore, the problem for the US equity market in particular is the combination of uncertainty caused by the trade war and the lack of an obvious valuation cushion.
In the UK, the inversion which began on 14 August appears to be destined to stay for the time being. A recession in the UK is clearly more likely given the challenges facing the country, but much can change in these volatile times and the range of potential outcomes remains quite wide. Once again though, unlike previous contractions, the impact of Brexit is the culprit rather than a more traditional slowdown induced by the Bank of England (BoE) and UK equities are cheap.
UK and US yield spreads (2-10 year)
There are now negative sovereign yields across Europe and a negative real yield out to 10 years in the US Treasury market (June CPI was 1.648% and the 10-year yield is now 1.60%). The Congressional Budget Office (CBO) also forecasts that the US budget deficit will exceed US$1 trillion this year and it will continue to deteriorate for the next decade, implying little wiggle room for fiscal stimulus if required.
James Ferguson at Macro Strategy Partners points out that “previously cautious bond fund managers have now been forced to throw in the towel” with regard to the downside risk for bonds. James reminds us that 12 months ago, 4 out of 5 global fund managers were reportedly expecting the rate of inflation to rise over the following year. At that time (July 2018) US CPI was nudging +3%, mainly driven by an oil price (West Texas Intermediate) that was up more than +70% year on year (yoy). The striking change in the inflation outlook since then has been largely brought about by the 35% decline in the oil price from the October 2018 peak and we suspect that we are now close to an inflection in the roller coaster of inflation expectations. The year-on-year change in the oil price looks likely to inflect back up to black and take inflation expectations up with it.
Oil and US inflation expectations
Current G7 country yield curves raise some challenging questions for policy makers looking to stimulate growth. For banks, low or negative rates and the flatter yield curves reduce lending margins and the propensity to lend accordingly.
For consumers, Gerard Minack suggests that the propensity for savings has a tendency to fall as wealth rises – a phenomena he links to conditioning of expectations with regard to the sustainability and persistence of wealth through cycles over time. Experiences as severe as the financial crisis are likely to have been particularly effective in training us to have more stable wealth expectations compared to the state of wealth at any given time, and more likely to save for a rainy day when things are good.
He also highlights that savings appear to rise as interest rates move closer to the ‘zero bound’ as savers look to maintain a required level of income – a dynamic that economists term the loanable funds theory. It would also be reasonable to assume that this counterintuitive decline in the elasticity of demand for money is likely to be more pronounced in countries with an ageing demographic or high dependency ratio, a characteristic that encompasses most of the developed world. In these conditions, it is possible that financial repression now counteracts monetary policy to the extent that it is becoming ineffective – a dilemma first identified at a Fed meeting in 1935 that coined the phrase ‘pushing on a string’.
The pushback to the loanable funds theory is that it ignores the leveraged impact of excess saving through the banking system on investment in the ‘real’ economy. Keynes supported this view noting the importance of the “behaviour of money between the first state and the last” and famously advocated stimulus via fiscal investment when animal spirits via private investment failed.
Financial repression and the ‘zero bound’
Source: Tilney (for illustrative purposes only)
Mario Draghi has been faced with the problem of the ‘zero bound’ for some time now and it is no surprise that he has frequently advocated that fiscal policy needs to play more of a role. We are also entering election cycles in the US, potentially the UK and also Italy, which look to be accompanied by an increase in fiscal spending. Even the fiscally cautious Germans appear to be considering additional spending to stimulate a flagging economy in addition to the current modestly expansionary medium-term budget plans. However, with growth stalling, Berlin faces a probability of revenue shortfalls that will badly squeeze its ability to maintain spending within the ‘black zero’ debt brake rules.
If investment continues to flag in the face of uncertainty, we believe that fiscal spending must and will take up the slack. Public infrastructure projects, rather than tax cuts, offer a higher return potential in our view and the cost of funding is certainly attractive! While infrastructure spending takes quite a long time to deploy and most governments do not have the luxury of strategic thinking, we believe that considering greater to exposure to infrastructure in our portfolios is now worthwhile. After all, the probability of success is higher when the tide is rising.
“Anarchy for the UK. It's coming sometime.” – The Sex Pistols
The Sex Pistols single Anarchy in the UK was released by EMI in 1976 but only reached number 38 in the top 40. God Save the Queen was released in April 1977 by Virgin and reached number 2, highlighting Richard Branson’s gift for spotting a trend!
The lyrics of ‘Anarchy’ include a selection of civil war references from 1970s headlines regarding various paramilitary groups in Ireland as a suggestion of what could happen if the disenfranchised youth of the day in the UK rebelled against the establishment. The parallel to the depth of feeling regarding Brexit is possibly slightly crass but the autumn promises to be a fairly rebellious period for British politics and momentous for our country.
The question we hear most often from clients relates to the implications of a Corbyn government for financial planning and our investment strategy. In this piece I will address the latter.
Firstly, it is important to keep things in perspective and remember that, in a global context, the politics of the UK are relatively inconsequential, particularly in a time when substantive issues such as the US/China trade war dominate. It is also worth noting that a Labour majority government is becoming increasingly unlikely with the Conservatives ahead in the polls* and favourites at the bookmakers** to win a workable majority.
In our view, if Jeremy Corbyn were to become Prime Minister, it would be in the context of a minority government. It would be conditional on supply and confidence agreements with the Liberal Democrats and the Scottish Nationalists, and this would moderate the implementation of the Labour Manifesto materially.
In either case, a Labour majority or minority, the probability of the UK remaining in the EU will be welcomed by markets. Sterling is already at the low end of its historical valuation range which limits the downside of a Labour majority and it has a good chance of appreciating in the event of the more probable outcome of minority control.
With regard to a Labour majority, despite the modest positive of an extension to Article 50 and without injecting any political bias, the consequence for UK equities and bonds is unambiguously negative.
If the Labour Party starts a fresh round of negotiations with the EU, it is highly likely that the impossibility of meeting the ‘six tests’ will result in the same impasse we have today, probably ending in yet another election and wasting another two years in the process. Therefore, a quick second referendum would appear to be the best option for Labour. A ‘Remain’ result would be simple enough to implement and a ‘surprise’ confirmation of ‘Vote Leave’ would serve to silence Remainers and give Corbyn his preferred choice with a clear conscience. Continued membership of the EU would have the benefit of moderating negative sentiment regarding Labour and its policies, some of which would be difficult to implement while part of the EU.
In domestic policy, wealthier individuals and businesses would be expected to foot the bill under a Labour government. Those earning more than £80,000 per year are in the crosshairs, while the gradual cuts being made by the Conservative government to corporation tax (currently at 19% with further cuts pencilled in) would be reversed and hiked to 25%-30%. Labour argues that business simply isn’t paying enough and needs to share more of the burden so that the majority of people – the poorest 95%, according to Labour – don’t have to pay any tax whatsoever.
On an assumption that the largest companies are able to mitigate a proportion of corporation tax on earnings and that any increases may be implemented over a number of years, it would be reasonable to assume that earnings for the MSCI UK would be initially revised down but only modestly due to higher tax rates.
The commitment to raise the minimum wage and push up lower-income salaries means that industries relying on low-cost workers will see margins come under further pressure. This will hit some industries already desperately fighting to survive, such as the retailers, quite hard – potentially leading to some pretty ugly headlines for the Government.
On the positive side, Labour also plans to unravel the years of austerity imposed by the Conservative government and increase borrowing in order to invest in public services. The party’s spending policies are the opposite of those the UK has adhered to for the last nine years, which brings both good and bad news for businesses. The focus on low-income spending threatens to funnel money away from some sectors, while higher infrastructure budgets could prove beneficial to others. Attitudes toward private companies earning money off the taxpayer in public sectors like the NHS, suggest that outsourcers who rely on government contracts could be in the firing line.
It is important to remember that Labour will publish a new manifesto should a general election be called, meaning that its exact policies are not yet known. However, it is likely that many of the commitments made in the last election and the party’s current ambitions will prevail and form the basis of the party’s promises.
Quantifying the impact
In August 2019, Oxford Economics published a paper which examines the potential economic and market impact of a Labour majority government. Their baseline assumption was that, post winning a majority in a general election (held before the end of 2019) and having restated the 2017 general election manifesto, there would be an extension of Article 50, followed by an orderly Brexit. Under these assumptions, they reach the following conclusions:
Rises by 2.5% of GDP (2.7% from higher current spending, 1.2% from higher capital spending and -1.4% from taxation)
The reaction of financial markets would depend on the perceived independence of the Bank of England. In a June 2019 speech, Shadow Chancellor John McDonnell reiterated his support for the conclusions of a 2018 report that he commissioned from GFC Economics. That report recommended expanding the BoE’s remit, including giving it a target of achieving productivity growth of 3% a year. In a world where secular stagnation concerns dominate, markets are likely to view such a high target as unachievable and Oxford Economics concludes that it would force the BoE to maintain very loose policy settings.
Corporate and consumer
The threat of rising personal and corporate tax rates has the potential to damage household and business sentiment. Also undermining the latter could be Labour’s nationalisation policy, particularly if the Government pays below-market prices for the assets it acquires.
Not our base case
A majority Labour government is not our base case assumption and an alternative scenario of a Labour minority would potentially be a net positive for markets and the economy. Our base case remains a business-friendly Conservative majority government where the burden of Brexit will depend on the final deal.
Global economic dynamics will continue to dominate global markets and in this respect, we expect that fiscal policy will be expansionary, monetary policy remains extremely accommodative, unemployment is low, real wages are rising and on the whole, equities are not particularly expensive. The trade war and politics have increased uncertainty for sure, and we advised reducing equities at the end of July to reflect this. Our position now simply reflects expectations for a more normal pace of appreciation and volatility compared to the bull market of the first half of the year.
Looking forward to the return of the House on 3 September, we will see if MPs can delay a ‘no deal’ Brexit. However, in a recent note and with the overwhelming support of the strategy teams of the various asset classes, the economic team at Barclays has now decisively moved to ‘no deal’ as a base case. In their opinion much of the bad news is priced in, but not all of it, and they broadly agree with our downside risk scenario (below).
Impact of ‘no deal’
- A mid-single digit correction in UK and European equities
- Foreign Direct Investment will remain frozen, implying that the currency will bear the brunt of funding the current account deficit
- The pound falls to US$1.10 and €1.00
- Unemployment will rise and GDP is likely to fall by 1.5% peak-to-trough via three quarters of negative growth before responding to a fiscal and monetary stimulus
- Fiscal spending to rise by £20-£40 billion
- Inflation would potentially rise by 1% through to 2021 although the deflationary impact of recession could mitigate this to some extent
- The income effect on consumption is estimated at -2%. In 2016, high savings rates provided a cushion to the reduction in income but this reserve does not exist today
It may seem that the smart thing to do would be to sit on the side-lines until we know the outcome. However, perfectly timing an exit and entry to avoid the downside is extremely difficult and an error of two or three days in volatile markets may eliminate all the benefits.
The UK has some terrific companies with fantastic global presence and many are already trading at a Brexit discount to their peers elsewhere. At present, capital investment plans are in limbo and the UK supply chain is full of inventory in order to deal with potential disruption. A decision one way or another will at least provide some certainty and normalise order patterns.
The currency, gilt and equity markets are likely to be volatile but the UK has been a pariah in the eyes of international investors for a while now. They may now use this volatility as an opportunity to pick up valuable assets on a discount. The stock market has a saying, ‘buy on the cannons, sell on the trumpets’, which has been around for a while and for good reason. It tends to work.
For more information or if you have any questions, please get in touch by calling 020 7189 2400.
*YouGov, August 2019.
**Ladbrokes, August 2019.
This article was previously published on Tilney prior to the launch of Evelyn Partners.