Investment Outlook

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June 13, 2019

Investment Outlook

Tom Elliott

Market sentiment: Jumpy. The stock market recovery rally of early June has petered out, as investors return to worrying over the implications of Trump’s trade wars. Government bonds of the major developed countries (the ‘core’) are in demand. The interest rate futures market is pricing in a 98% chance of a Fed interest rate cut this year after weak May jobs data last week and the Markit purchasing managers index (PMI) fell to its lowest level since 2009. The spread between the yields on three months and the 10 year Treasury is now negative, at -0.12; for some analysts, this signifies a recession in the U.S in the next 18 months or so. Some analysts expect a Fed rate cut as soon as July if there is no U.S/ China rapprochement at the late June G20 summit. 

Core government bonds have thrived on expectations of weaker growth, demonstrating the utility of having fixed income in a multi-asset portfolio. The U.S 10 year Treasury yield has shrunk from 2.95% at the end of April to 2.11% yesterday. In Germany, 10-year bond yields sold at auction went for a record low yield of -0.24%. This suggests that whoever takes over from Mario Draghi, as head of the ECB, will inherit unfinished business: namely convincing investors that the eurozone is not heading into a Japan-like environment, of structurally low growth, inflation, and permanently negative real interest rates. 

Why do Trump’s trade disputes matter so much? Tariffs deter international trade. Trade has been a major driver of global economic growth over the last 60 years, as countries exploit what classical economists (ie, Adam Smith, David Ricardo) refer to as their ‘comparative advantage’ with one another. This says that both parties benefit equally from trade, so long as markets - including the flow of finance- are free of interference. This idea underpins the World Trade Organisation (WTO), which polices global trade and is constantly driving for lower trade tariffs, import quotas and other barriers to trade. Trump’s economics is more mercantile, meaning he believes trade to be a zero-sum game at which one party wins more than the other, and that the state should help direct trade with the objective of managing it to 1) run trade surpluses, 2) influence political events abroad. He has no love of the WTO.

The Chinese leadership, for all its claims to be a defender of free trade and globalisation, believes much the same Mercantilist philosophy. And indeed, Germany and Japan have been criticised for most of the post-war period for fetishizing trade surpluses. This ideology causes friction: all countries cannot, by definition, be running surpluses. If those who run deficits believe that they are ‘losing’ in international trade, as Trump does, they will react by seeking to change the rules of the game.

The move by the U.S away from free trade matters, in particular, because it is the world’s largest economy and importer. This gives the U.S considerable scope for bullying its trade partners, with further leverage coming from the use of the dollar as a currency of choice in global trade, and as a global reserve currency held by central banks. Furthermore, having been a key cheerleader for free market trade in the post-war years, its about-face weakens the ability of other free-trade orientated countries to hold the line against mercantilist supporters in their own countries (often to be found in the new brand of populist politicians).

It is not tariffs per se that worry economists and investors. Small tariffs on imports of 5% are easily absorbed by most industries. But 25% tariffs can destroy profit margins if they cannot be passed onto the final consumer, and if they can then there is by definition less available spending on other goods and services in the economy. There is also a fear that tariffs are being used by the White House outside of trade issues. Last week’s threat of tariffs against Mexico, over the migration issue, has shown how Trump is willing to mix trade with other issues. Many believe that his complaint against China’s trade practices is as much based on geopolitical rivalry as it is on genuine trade issues. This means tariffs look set to be imposed, and lifted, in an almost random manner that will deter international investment and trade flows, and global growth.

Turning Japanese? The recent sharp fall in core government bond yields around the world reflects investors’ near-term preference for defensive assets, as Trump adds countries, companies, and individuals to his list of foes. But it also reflects investors’ lack of belief in the ability of central bankers to successfully ‘normalise’ monetary policy. In other words, to bring interest rates, bond yields, and inflation back to pre-2008 financial crisis levels. 

With mediocre global GDP growth at present and relatively weak inflation in the major economies, it is difficult to see where the drivers for higher interest rates and bond yields will come from. Trade tariffs add to deflationary pressures, as do demographics-  since baby boomers in the west seek fixed income investments for their pensions, and Asian savers recycle trade surpluses into core government bond markets. The ultra-low interest rates that have existed in Japan for 20 years are becoming more normal in the west with every passing day. 

This has implications for investors. The much-anticipated crash of the bond market looks like being further delayed. We may have to wait for China to run large current account deficits (ie, absorb global capital), and the heirs of today’s retirees in the developed countries to spend their inheritance before pre-2008 monetary conditions return and yield curves steepen. Value stocks with high and secure dividend pay-outs may outperform growth-orientated stocks, and those with weak balance sheets that look to inflation to reduce the real value of their debts.

Is the economy safe in Conservative hands? Many of the candidates in the current Conservative party leadership contest appear to relish the prospect of a no deal Brexit, even as they claim the idea to be a last option. This is despite warnings from virtually all economists that a no deal could be chaotic for the U.K economy, and trigger a recession. Many of the candidates are also offering tax cuts should they be chosen by the party membership, greedily eying the Treasury’s £26 billion no deal ‘war chest’ as a source of possible funding for their largess. This has been carved out of the public finances by Chancellor Philip Hammond in order to boost public spending, and so support the economy, in the event of a no deal Brexit. 

Sterling, always nervous of talk of a hard Brexit coming from a no deal, has weakened in response. Some commentators wonder if the Conservative party is about to destroy its historically most potent claim over the Labour party: that the economy is safe in its hands. Although the hurdle may be quite low, given the Marxist sympathies of the opposition Labour party leadership.

A no deal Brexit on 31st October will see further falls in sterling. However, a second referendum, a general election, or even a revolt by Remain-supporting Conservative M.Ps against the new prime minister in a vote of no confidence, may yet scupper this least-desirable Brexit outcome. If so, a sharp rally in sterling and U.K risk assets, in general, can be expected, as a wave of pent up spending creates a mini economic boom. Once again the Bank of England will talk of raising interest rates (but note: under governor Mark Carney, the Bank of England has developed a reputation of more talk than action).

A multi-asset portfolio for the long term. Many long term investors favour investing in a combination of global equities and bonds since the two asset classes have a relatively low correlation with each other and so offer diversification benefits. Below is an illustration of a typical 60% equities/ 40% bonds fund. The exact ratio of equities and bonds will reflect a client’s risk profile and investment horizon.


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