February 06, 2017
Investment Outlook 5 February 2017
Tom Elliott's fortnightly review of global capital markets
Broad economic and political assumptions: Trump’s fiscal stimulus will pass Congress and the Fed will exercise caution in its rate hikes, resulting in a stronger dollar. We will see stronger U.S domestic demand, rising inflation, and increased imports. Emerging market companies and sovereigns will suffer from the burden of carrying approx. $9 tr of dollar-denominated debt. Trump holds back from instigating a tariff war with trading partners, instead using WTO dispute mechanisms. Populist politicians fail to take control in this year’s Dutch, French and German elections, not least because of a recovery in the euro zone economy. Sterling weakens as a ‘hard Brexit’ increases uncertainty, leading to outperformance of multinationals over domestic-based stocks.
The chart above shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor.
Taking the above assumptions into account: We might see over the next year to 18 months equities outperform bonds, with developed equities outperforming emerging market equities. Within the U.S, small and mid-cap stocks might outperform large cap stocks. European and Japanese exporters might also do well. Within fixed income, short duration and limited exposure to high yield might yield the best results.
This week: Solid global economic data vies for attention with Trump. Trump and tax – bad news for U.S High Yield? U.K M.Ps bamboozled by Brexit. Oil prices: as good as it gets?
Solid global economic data vies for attention with Trump
- Global capital markets continue to be driven by U.S politics as much as by economic sentiment, which has been supportive. Friday’s rally in U.S investment banks illustrates the point: it was triggered by the Trump administration announcing it will seek to amend the Dodd-Frank regulations introduced after the 2008 financial crash.
- But economic data has been solid. The Bank of Japan has increased its GDP forecast for the year to March 2017, from 1% to 1.4% growth, citing lose monetary and fiscal policies and a pick-up in overseas growth. Given Japan’s falling population, according to an economist quoted in the Financial Times, that 1.4% growth is the equivalent of 3% GDP growth in the U.S. Robust business surveys and consumer confidence indies in the Eurozone supported the optimism over stronger regional growth, and the region’s ability to absorb a ‘Brexit shock’. Fourth quarter Eurozone GDP data came in at 1.8% year-on-year. The U.K economy grew 2.2% over the same period, thanks to strong consumption growth as households draw down savings. In the U.S fourth quarter earnings continue to beat analysts’ expectations, with average S&P500 earnings so far up 8% over the same period in 2015, against expectations at the start of the year of a 6.1% gain.
- However investors are transfixed by the new Trump administration. The President has taken to pronouncing on the dollar, something the White House traditionally avoids doing. He has accused Germany and Japan of keeping their own currencies cheap through monetary policies such as quantitative easing and maintaining current account surpluses. There is much truth in this claim, but it ignores the boost that the U.S itself had from a weak dollar when the Fed introduced quantitative easing policies from late 2008, ahead of Japan and the ECB. Furthermore Germany itself has long been opposed to the ECB’s loose monetary policies, despite its exporters benefitting from the cheap euro.
- Trump has not yet got into a spat with China over its alleged dumping in U.S markets, leading to speculation that he may prefer to use WTO dispute mechanisms. However, there remains a significant danger that he chooses to take the U.S out of multilateral organisations and this may extend to the WTO itself, as well as the Basel bank supervisory body.
Trump and tax – bad news for U.S High Yield?
- Below is a brief summary of the proposals on tax reform. There will be intense lobbying before the dust is settled, and no doubt many loopholes for special interest groups.
- Most notable is a proposal to end the ability of companies to write off debt interest against taxable profits, a practice imitated around the world and that is widely criticised for contributing to financial instability. It favours debt funding over equity balance sheet funding, so increases corporate leverage and the risk of insolvency during a downturn. It also reduces the number of those who hold equity in a successful company, and so who benefit from its success, which feeds into the wealth inequality argument that is helping drive populist politics. This may, however, cause problems for the U.S high yield bond market (formerly known as ‘junk bonds’), where the inability to write off interest costs is likely to have a disproportionate impact on profits than on higher quality, investment grade, issuers.
- The corporate tax rate may be reduced from 35% to 20%, and there is a proposal to allow investment spending to be written off immediately against taxable revenues rather than spread over several years. This would make the U.S tax-competitive compared to many E.U countries, undermining incentives for ‘tax inversion’ M&A activity by American companies.
- The ‘boarder adjustment tax’ (BAT) discussion rumbles on. This will remove companies’ ability to deduct import costs from taxable revenues, while making any profit from exports tax-free. This has the potential to significantly disrupt the supply chains of American multinationals, while favouring domestic manufacturers. While obviously a protectionist measure, that will probably raise prices for the American consumer, it will help counter the habit of U.S multinationals of keeping export revenue in un-productive cash (and, to the ire of many, in overseas subsidiaries). If implemented, it may be imitated elsewhere.
U.K M.Ps bamboozled by Brexit
- The House of Commons last week passed a bill (498 votes in favour to 114 against), authorising the government to proceed with Brexit negotiations. The debate highlighted confusion amongst many Members of Parliament as to whether they should vote in a manner that reflects their constituencies’ voting during the referendum, the overall vote of the referendum, the official position of their parliamentary party, or of their conscience. This is an age-old conundrum which bamboozles M.Ps and which Brexit is highlighting as rarely seen before.
- A small majority of Conservative M.Ps actually supported the Remain campaign in last June’s referendum, but they have now been cowered by the party leadership and the pro-Brexit press, which has shown by its recent attacks on Supreme Court judges that no insult is too low to fire where there may be opposition to Brexit.
- Of the Conservative Party only the former Chancellor Ken Clark voted against the bill. His speech pointed out some of the difficulties that the government may face on leaving the E.U: “Apparently you follow the rabbit down the hole and you emerge in a wonderland where suddenly countries around the world are queuing up to give us trading advantages and access to their markets that previously we had never been able to achieve as part of the European Union,” he said. “Nice men like President Trump and President Erdoğan are just impatient to abandon their normal protectionism and give us access. No doubt there is somewhere a Hatter holding a tea party with a dormouse.” https://gu.com/p/5p2my/sbl
Oil prices: as good as it gets?
- The forward curve for Brent crude suggests the market is sceptical that oil prices will rise. Today’s spot price is $56.8, it is $56.5 for September delivery and thereafter the price is flat until 2021. This is despite the apparent compliance by Saudi Arabia, and other key oil producers, to November’s agreement between OPEC and some major non-OPEC countries to curb oil production,
- This could reflect one or several of the following factors. First, a history of non-compliance amongst OPEC members to output curbs agreed amongst themselves. Including several large non-OPEC producers (notably Russia) add to the risk of failure. Second, the U.S shale industry has shown remarkable resilience. The Saudi’s failed to bankrupt the sector over the two years up to last November, despite having ramped up production to record levels. Third, stockpiles and supplies of crude and refined oil remain plentiful. Finally, there is the risk that long term demand remains stagnant if the use of renewables and energy efficiencies counter the demand-boost from a stronger global economy.