Our broadly positive stance on equities has been predicated on two key factors. Namely, a more accommodative Federal Reserve (Fed) and fiscal stimulus in China that would drive economic momentum in the second half of the year. We considered the principle risks to this outcome to be an inflation shock that forces the Fed to raise rates or a negative development with regard to trade discussions between China and the US.
As we approach mid-year, we are relatively confident that inflation remains an unlikely catalyst for a change. Thanks to a weaker trend in healthcare inflation and a stable housing component, the US core inflation rate has been trending down over the past couple of months despite a healthy increase in wages (see below chart).
Commodity prices overall have also dampened inflation expectations, with a fall on aggregate of about 15% year on year. They will likely remain a ‘deflationary impulse’ until late Autumn at the earliest. Therefore, the probability of an increase in interest rates by the Federal Reserve in response to inflation has diminished and investors have been gobbling up long-duration Treasury bonds. The combination of a moderation of global growth and inflation expectations has taken the yield on a 10-year US government bond to just 2.33% at time of writing versus 3.24% on Armistice Day last year.
In the UK, a similar dynamic has been compounded by an additional Brexit twist and 10-year gilt yields have almost halved since the heady days of optimism in October, to just 0.92% today. With core CPI at 1.8% year on year in the UK, the implied compound real return on lending money to the Treasury for the next 10 years is a relatively unappealing -8%.
Falling bond yields are not a good omen to equity investors who, like us, had been expecting growth to recover in the second half of the year.
The path of monetary policy in the US has moderated as expected, China has eased fiscal policy and credit growth is recovering but our concern is that the escalation of the US/Sino trade war will undermine our base case assumption.
So far, the experts do not estimate the macroeconomic impact to be material. Oxford Economics has lowered their China GDP forecast in 2019 by just 0.1% from 6.3% to 6.2%, which is essentially a rounding error and their principle focus is on aggregate demand in the domestic market. Retail sales continue to disappoint, despite the reduction in VAT on 1 April and fixed asset investment is also weaker than expected. However, real estate investment remains robust with housing starts up 18.5% year on year and imports rose well ahead of expectations.
In short, the signals are mixed and it is too soon to say whether the negatives associated with the US trade discussions will be more than compensated by the monetary and fiscal stimulus policies implemented late last year.
A pragmatist (or cynic) would suggest that President Trump is practicing 'the art of the deal’ with an eye on the election in 2020 and intends to declare victory post the scheduled meeting with Xi Jinping at the end of June, reasserting American primacy in the world order.
The problem with this scenario is that the global supply chain is incurring a fair amount of collateral damage in the meantime. The policy of imposing sanctions on companies on the so-called Entity List is also likely to lead to damaging retaliatory action at the company level.
In my view, the prevailing consensus regarding US policy ambitions on trade is complacent. The rise of China is a fundamental challenge to American hegemony and an existential issue for the Trump administration. To quote the American athlete, Mike James – “Any dog, you put him in a corner, no matter if they’re vicious or not, they’re going to bite back” and the US is biting back.
Episodic volatility is the most probable outcome and something we will need to get used to as the two powers wrestle for position. The US/Sino tension is the now commonly referred to as the new Cold War. Neither party will concede easily but unlike Russia, China will become stronger rather than weaker over time. In the short term, we appear to be in for a bout of muscle flexing that will probably take some of the froth out of the market.
On the domestic front we have a war of a different sort. There is no doubt in my mind that the UK equity market is cheap and looks more like an asymmetric trade in terms of risk and reward, but politics adds material uncertainty with regard to the timing. In the words of the legendary Morgan Stanley strategist Barton Biggs, “markets can be irrational for longer than you can remain solvent” and the tail risks for the UK have risen.
The change of leadership in the Conservative Party increases the probability of both a hard Brexit and the possibility of a general election where the outcome is increasingly difficult to predict.
How to call an election
A standing government is not required to seek dissolution of parliament once the new prime minister is in place. An election requires that the Commons resolves whether “there shall be an early parliamentary general election" with a two-thirds majority or it can vote that “this House has no confidence in Her Majesty's Government", with the caveat that the House does not subsequently resolve that "this House has confidence in Her Majesty's Government". There is also no law that requires a government to resign if they lose a no confidence motion in the house – just convention.
If a government does resign after the loss of a no confidence motion there is a period of 14 days available for someone else to put a government together and to put the motion to the House that it has confidence in the new government. If this fails or if after 14 days no government can be put together then the House is dissolved and a general election is called. This must be held 25 days after dissolution.
In the short term, a new prime minister could call for an early election to capitalise on the momentum of his or her victory under the two-thirds rule or, alternatively, legitimately look to make progress on Brexit before going to the country. However, since neither the Conservatives nor Labour will be keen to go to the polls in the immediate future given the drubbing at the recent European election, a vote of no confidence appears unlikely.
If a no confidence vote is tabled by the opposition, it is by no means certain that the Government would win. The numbers are very finely balanced and we estimate that just four disenchanted Tories could trigger an election. In practical terms, the odds seem more in favour of 2020 and with a stack of wood to chop between now and then, making a prediction becomes much more difficult.
In our view, the outcome of an election will be very dependent on the quality of the campaign. Corbyn has the edge based on track record and the new Tory leader will need to be someone who can bring passion and purpose back to the party, with a little more charisma than the Theresa May. Based on the latest polls, the Conservatives have a lot of ground to make up and their prospects do not look particularly good.
Source: British Polling Council
The variables to be considered in a prediction of actual seats in the UK are somewhat overwhelming but, if we had a flame held to our feet, the conclusion would be that Labour will be the largest party by a margin of 55-60 but with no overall majority. In this scenario, Labour would need to seek a coalition or at least a supply and confidence agreement to survive in power.
The prominent dance partners are the Scottish National Party (SNP) and the Liberal Democrats, which in our opinion makes a coalition seems very unlikely, leaving a supply and confidence agreement as the most likely outcome. The SNP is sure to ask for another independence referendum for their fealty and, most importantly for investors, Labour will struggle to implement their most radical policies without a majority.
This critical point is something to consider before reaching for the suitcase. For international investors a government in paralysis but with a manifesto to stay in the EU would not be a bad outcome and may well create temporary schizophrenia in both the currency and equity markets as they weigh up the positive and negative implications. The UK is unloved at the moment and assuming that most of the bad news is in the price, the net positives could win the day.
However, with no prospect of any clarity in the short term, it is highly likely that the economy will lose momentum in the second half of this year. The pound is likely to continue to struggle, particularly if the rest of the world recovers, but this would boost the translation effect of the 75% of the largest UK companies’ revenues that come from overseas. Under the assumption that government policy continues to be business friendly, the global economy remains the dominant factor for UK large-cap companies, but that basic assumption is fragile.
If a week is a long time in politics, the next six months could well seem like an eternity.
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