Investment Outlook

read on...

December 13, 2019

Investment Outlook

Tom Elliott

Market sentiment: Good news flow is continuing to support risk assets. This includes the prospect of an imminent agreement to the so-called Phase One of U.S/ China trade talks, and a large Conservative Party win in the U.K general election, with both taking place against continuing improvement in global economic data (the U.K and Germany being notable exceptions). The S&P 500 index of large U.S stocks is at new all-time highs, while in the U.K the domestic-focused FTSE 250 index rose 5% in the first twenty minutes of trading this morning. Core government bond yields (ie, their prices are down) are up as the outlook for global growth, wages and inflation, continue to improve.

U.K election. Don’t expect to see a rush of pent-up investment and consumer spending after today’s convincing electoral win by the Conservative Party. The 1.5% rally in sterling over the dollar so far today and strong gains for domestic-focused stocks reflects relief that a 1970s-style socialist Britain is not making a reappearance. The Labour Party comprehensive drubbing at the polls must surely lead to a re-think of its recent lurch to the left. The market’s moves do not necessarily reflect a positive view of the Conservative Party: it is worth noting that the 78 seat Tory majority was achieved with only a 1% increase in the share of the vote, compared to the previous election, whereas Labour lost 8%.

However, the U.K does now have the first Conservative government with a large majority since the days of Margret Thatcher. And the party is traditionally business-friendly, and relatively competent in handling the economy. Johnson’s promise to be a ‘one nation’ Conservative prime minister will, it is hoped, temper the populist in him that sometimes appears to be anti-business and pro-state aid and intervention. 

However, on Brexit, his campaign promise to ‘Just get Brexit done’ will run into reality, Business, and investors will be watching nervously.

The Withdrawal Agreement part of Brexit looks set to be passed by the end of January when the current extension to Article 50 expires. But the second part of Brexit, negotiating the future trading relationship with the E.U, has not yet started. And here lies a problem for U.K business (and investors in U.K assets). Johnson has promised it will result in a ‘Canada minus’ trade deal with the E.U, and be done by the end of 2020 or he will walk away from negotiations and risk a chaotic no-deal Brexit. 

The self-imposed deadline, together with the promise of a trade deal that offers less even than the one recently signed between the E.U and Canada, were done to attract hard-line Brexit voters. But both the artificial deadline and the very loose relationship with the E.U envisaged risk chaos for the U.K business. It is to be hoped that Johnson’s majority in Parliament means he can backtrack on both points - after all, a trade deal in which the U.K remains in close alignment with the E.U will be easier, and quicker, to negotiate.

But even if Johnson does renounce both the deadline and the ‘Canada minus’ objective to the negotiations, U.K business and investor confidence is unlikely to improve dramatically for the following reasons:

First, the closer the U.K remains to the E.U, the harder it will be to secure trade agreements with third countries that have different product regulations. This risks the U.K being -for a while- in an inferior economic relationship with the E.U than at present, with nothing to compensate this from new trade deals elsewhere. Indeed, most economic models of Brexit show remaining in the E.U as the least-worst option for the economy over the coming decade. 

Second, the success of the SNP in Scotland, which won 48 of the 59 seats, means Johnson will be under intense pressure to allow a second independence referendum. If such a vote is held, and Scotland wins independence from the U.K, business and Westminster will have a fresh set of problems on their table while dealing with Brexit. Business planning for U.K companies will enter another level of frustration.

Third, are financial markets ready for a big-spending Tory government, or voters ready for a continuation of tight public spending as implied by the government’s budget forecasts? Johnson implied on the election campaign that, once Brexit is ‘done’, Britain’s longer-term structural problems can be addressed. Such as social care, the NHS, investment in infrastructure (eg, the Northern Powerhouse). However, funding these will need increased borrowing, since the Tories do not have any new revenue-raising plans (aside from not implementing a previously planned £7 bn corporate tax cut). As the Institute for Fiscal Studies has observed, addressing these issues will be impossible if the government is to meet its target of a balanced budget by 2022-23. And if it does address the problems with meaningful sums of cash, will the demand for an increased supply of gilts be strong enough to keep yields low and government borrowing costs down?

U.S/ China trade deal by Sunday? President Trump’s deadline for an agreement of this coming Sunday has focused minds, and a trade deal of sorts with China appears likely. If there is none, a new round of U.S tariffs on imports of Chinese manufactured consumer goods will apply. We have been close to an agreement several times before in the current spat, only for talks to end in acrimony. However, Trump wants a trade deal ahead of his re-election campaign. And the risk to China of playing a long game with the U.S over trade talks is highlighted by recent trade data. Existing tariffs (and fear of fresh ones) have contributed to a 25% fall in Chinese exports to the U.S over the 12 months to November. This comes at a time when stricter credit rules are slowing the pace of domestic demand growth, so increasing the pressure to grow exports in order to maintain aggregate GDP growth of around 6%.

A trade deal will ease pressure on the U.S tech sector in particular, and global trading companies in general. One feature of the trade war has been the extent to which it has dragged in third countries, who perhaps have supply chains in the U.S or China, and find that they cannot sell the product to the other country without coming against tariff and quota barriers. 

Phase Two? The content of Phase Two of the talks is deliberately vague. It is understood by U.S officials to include topics which, officially, China regards as off-limits, such as state aid and China’s poor record on obeying WTO rules on trade. The Chinese will be hoping that Trump pushes Phase Two into the long grass, and instead focuses on the ‘win’ of Phase One for his domestic audience. But Trump is unpredictable and may see advantages in insisting on talks starting immediately on Phase Two since he has often spoken against China on these issues. 

<< International Investment Strategy