The earlier months of 2018 have seen financial markets make only modest progress. In the US, at the time of writing, the SNP 500 has risen slightly over the period while the Nikkei 225 and German DAX indices are both a little lower. The FTSE 100, on the other hand, is substantially unchanged. While a number of markets have progressed over the last twelve months, the last six have generally been stagnant. In the meantime, Sterling has dropped about 8% against a generally stronger Dollar since its highpoint in April although it is up by approximately 1% against the Euro since the beginning of the year. Fixed interest markets in the UK have been relatively stable. The headline figures do however mask the return of some volatility after the best part of a decade of generally rising markets.
Improving company profits have been generally supportive of equities against the background of, for the most part, steady global growth. US equity markets, and indeed the Dollar, have been beneficiaries of Donald Trump’s tax cuts while rising interest rates in the US have boosted the Dollar relative to other currencies.
One of the features of the aftermath of the financial crisis some ten years ago was the emergence of an informal global central bank consensus on necessary actions to restore confidence, principally in the form of quantitative easing. The effect was to pump money into economies, restoring confidence in the process. It has taken time to work, and indeed QE still continues, albeit on a modest and reducing level, within the Eurozone as well as Japan. The US has however moved away from the need for monetary stimulus rather earlier than elsewhere and as a consequence now continues to tighten monetary policy in order to curtail excessive expansion and possible inflation that might go with it. Thus the post crisis consensus no longer applies. You may remember what became known as the “taper tantrums” roughly three years ago, when QE in the US was reduced. One impact then, which we are seeing again now as the US moves to a different phase, was that the value of emerging market currencies was in some cases considerably dented. This year, the impact has been felt by a number including, notably, the Turkish Lira, the South African Rand and others in particular where local domestic political troubles have also added to uncertainty.
Before turning to the market outlook as we see it, we comment on two current issues which may be of interest to you, as follows:
Readers will know that protectionism takes place when a country seeks to shield its domestic industries from foreign competition. There are various ways in which this might be implemented, the obvious one being the imposition of tariffs but non-tariff barriers can play a major role, these including import quotas, embargos, sanctions and the introduction of higher product standards.
The US Great Depression of the 1930’s arguably resulted from a decision in the US to raise tariffs on many thousands of imported goods, from levels that were already high. This was combined with weak money and credit growth (economists debate which came first but in our opinion the two went substantially hand in hand). Other countries retaliated and there was a collapse in world trade of 25% in the period 1929 to 1930. This had major repercussions across the globe, including large falls in stock markets. Currently we are nowhere near to that situation.
For some years now, global trade has grown relatively strongly and there has been a general trend towards reductions in tariff rates, to levels that are way below anything seen during the 1930’s. However, the subject is re-emerging, initially focussed on trade between the US and China but now spreading to that between the US and its immediate neighbours and the EU (including the UK). The vast economy of the USA relies only to a limited extent on exports of goods and services to support its GDP (approximately 12%). At the other end of the spectrum, the German economy is driven as to some 45% by exports, with the likes of Mexico, Canada, France and the UK at various points in between. The conclusion that we draw is that it is much easier for the US to appear to “win” (Donald Trump’s word) trade wars as, relative to the size of its economy, it has much less to lose.
Significant tariff increases would be most unwelcome, having the effect of reducing global trade, supporting inefficient businesses and inflating the costs that consumers pay, in effect depleting their overall spending power. It remains to be seen how this matter will develop over the coming period: at this juncture we regard it as a headwind against markets, as a cause for concern but not as a crisis.
As an example of unintended consequences, in response to US tariffs on EU goods, the latter is placing tariffs on a number of US goods, including the iconic Harley Davidson motorbikes. As a consequence, Harley Davidson plan to reduce US production and increase it in factories in India, Brazil and Thailand as bikes produced in those locations will not be subject to the EU tariffs. Immediate losers have been Harley Davidson shareholders because, and as an interim measure, the company will absorb the cost of tariffs on its exports to Europe. Longer term losers will be those who supply Harley Davidson in the USA and workers who make the bikes there. Winners will be the supply chain and workers in the three developing countries while if the manufacturing costs outside the US are generally cheaper than those within, and if standards can be maintained, further US jobs may be lost over time. Undoubtedly not Mr Trump’s intention.
We make no apology for returning to the subject of Brexit where major issues remain absolutely unresolved. In so many vital economic areas the government has not yet provided clarity of purpose, without which it is very difficult for meaningful negotiations between the EU and the UK to take place. The broad reason for this is that delivering Brexit is an almost impossibly complicated task in ways wholly misunderstood at the time of the referendum. As the process grinds onwards, a number of points are clear to us.
Firstly, we need to consider what a good deal for the economy might look like, and whether such an outcome is at all likely. In our view, a good economic deal would leave the UK within, or as close to as makes no difference, the customs union and the single market, together with “passporting” in financial services. If such a deal were to emerge we anticipate that Sterling will appreciate in the short term, with a corresponding fall in the FTSE indices as foreign earnings become less valuable, at least for the moment. Given the political implications that would be attached to a ‘good’ deal, this outcome appears improbable.
We believe that a relatively poor deal (economically) is more likely and that risks to the UK government’s financial position over the next decade are increasing. Growth in the UK economy for the first quarter of this year stood at just 0.2%, half the growth experienced in the Eurozone. While we expect some recovery in the second quarter, latest manufacturing and construction data suggests that this will be weak. Given that government revenues from taxation are driven by the performance of the economy, this paints a gloomy picture at a time when there is pressure to increase expenditure in so many areas. We do not agree that eventual trade deals between the UK and the USA, or China, or Commonwealth countries stand any reasonable chance of sufficiently protecting UK GDP over the five years or longer after the end of any post Brexit transition period. After all, the UK already trades with all of these from within the EU, although interestingly on a smaller scale (relative to GDP) than does Germany. In the meanwhile, trade in both goods and in services with the EU, on which we rely heavily, inevitably faces disruption, potentially significantly so, once any transition period concludes. The Foreign Secretary talks of ‘some pain’: our opinion is that he materially understates the magnitude and duration of the risk. If this is correct and if there is a poor deal, or worse, no deal, then over the coming decade the government will face significant funding problems (overwhelming the impact of the UK’s eventual cessation of payments to the EU) which can only be plugged by greater borrowing (it is already too high), implying higher interest rates than would otherwise be the case, and/or higher levels of taxation across the board. This leads us to be negative on the value of Sterling, we anticipate greater medium term inflationary pressure as a consequence and there is the potential for a protracted bear market in Sterling denominated conventional fixed interest investments.
The potential for equity investment in the UK arising from an economically poor deal is however very different. As we have often pointed out in the past, the substantial bulk of the turnover and profits of the UK’s leading companies are derived from their overseas activities, providing protection against any further depreciation of Sterling. These companies are already and will continue to invest close to their main markets and many are well equipped to compete globally. This notwithstanding, Brexit uncertainties have weighed on UK equities relative to their global counterparts: this may be unfair and as part of a balanced range of equity investments, UK funds in our view have a part to play.
We believe that continuing lower interest rates across Europe and the Far East remain supportive for equities. It is also worth noting that although interest rates in the USA have risen, and looks set to increase further, the overall pace is gradual. Companies can borrow money for investment on a relatively long-term basis at low cost, a factor that looks set to remain supportive for equity markets for some years and despite some reduction in the level of cover, we believe that recent higher dividends will be maintained. We do however consider that investors should expect greater volatility over the next couple of years, given issues discussed in this note together with increasing geopolitical risk, providing attractive opportunities for long term thinkers.
In the medium term we are less sanguine in respect of the outlook for the fixed interest sector. We anticipate that interest rates may begin to rise in the Eurozone later next year, by when both USA and UK interest rates are likely to be higher than they are now. This is a difficult backdrop for the fixed interest sector, however we recognise its importance for income seeking investors and generally as a counterbalance against more volatile equities. We therefore approach the sector with care, selecting funds where we believe managers have the freedom and skills necessary to deliver defensive fixed interest strategies.