The outlook

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08/08/2018
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Readers may be forgiven if they are confused about recent financial market and economic developments. I feel a tad confused myself. Although, as we suggested last time, the media reaction to the equity market volatility of the first quarter was shown to have been overdone and markets recovered their poise, helped by continuing strong economic data, recent moves have been driven by political developments of a most confusing kind. Many of which were caused by that most maverick of politicians, Donald Trump.

Strangely, the agreement reached in Singapore between the US and North Korean leaders – to achieve the complete denuclearisation of the Korean peninsula – had very little wider market impact. Probably because there was a good deal of scepticism in the aftermath about whether the deal would hold and also because of the limited impact of the deal outside of the region.

Far more meaningful have been the US President’s trade decisions - starting with the tariffs imposed upon imports of aluminium and steel, irrespective of their state of origin. Since May, hardly a week has gone by without the announcement of at least an intention to impose tariffs upon yet another range of goods, either by Trump himself or by one of the trading ‘partners’.

These moves have certainly aroused diplomatic tensions – as evidenced in the by now famous picture of Trump seemingly being harangued by the assembled members of the G7 at their summit in May. The random nature of threats has been disturbing. The use of the ‘national security’ pretext is spurious. Markets just don’t know how far this could go but, on the other hand, in some ways the reaction has been surprisingly muted. This is partly because it is becoming clear that the main object of Trump’s ire is not the global trading community, but China. China is the source of the largest component of his trade deficit and becoming a major global military power. Trump has shown himself very capable of reversing policy in respect to China if it suits him. Partly too, it is because markets recognise that while the progress of globalisation may be in the process of being reversed, it is far too late to turn back the clock now. Effective tariffs on goods in the developed economies are extremely low by historic standards – this is what successive rounds of World Trade Organisation talks and deals have achieved. The limited measures that have been announced so far would not have a meaningful impact upon overall trade volumes.

Finally, in recognition of the fact that the trade measures are likely to have a more damaging impact upon the US economy than positive, business is beginning to fight back and lobbying for their reversal. While it is unlikely to have much effect, given that Trump is only putting into effect campaign promises made to his narrow support base, this should halt further expansion.

Italian coalition creates euro uncertainty

Two other factors have demanded investor attention in recent weeks. First was the result of the Italian election and the continuing search to find a viable coalition. That the first manifestation of that coalition, a combination of the far right and left, could only agree on one thing – their opposition to the Euro was not a good sign when the President tried to avoid a rerun of the 2011-12 Euro crisis by vetoing their choice of Finance Minister, that only served to indicate to investors that a rerun was more likely. For now, calmer counsels have prevailed but peripheral Euro yield spreads have widened as markets prepare for further potential instability.

Impact of oil price & US dollar strength

The second is the behaviour of the oil price accompanied, unusually by US dollar strength. A number of factors were behind the former – global demand growth, OPEC restraint, crisis in Venezuela, compounded by Trump’s declaration of full-scale commercial war against Iran. This accompanied by dollar strength was damaging for emerging markets where we saw signs of stress in Argentina and Turkey, but very positive for oil exporting economies and commodity-rich equity indices, notably the UK.

This factor, plus the excessive reaction to Q1 news, was behind the very strong performance of UK equities in Q2. In the middle of all this, the UK scene continues to be dominated by Brexit. I recognise that, given the strong views held by many on this subject on both sides of the argument, that the following is inevitably going to offend more than a few. But the picture is becoming a little clearer – but increasingly fraught given the pressure of time. Frankly, the UK conceded any kind of bargaining power it had when it triggered Article 50 early. Various Parliamentary debates concerning the extent of that institution’s continuing influence upon the process have come and gone, inconclusively. Leak and counter-leaks have emerged from both wings of the Conservative party. The Labour opposition too is almost as divided. But the Irish question holds the centre stage. As soon as UK politicians concede the EU position that placing any kind of customs infrastructure at the Irish border is a non-starter, then they also concede our continuing membership of the Customs Union and some aspects of the Single Market. Failure to recognise this is having a damaging impact upon business and the economy as time marches on – which the recent warning from Airbus has indicated. However, the Brexiteers are unwilling to do so and the response of the Prime Minister is not to stand up to them, but to fudge. In these circumstances, the danger is that we have an almost permanent Brexit process, one in which uncertainty about the future is so pronounced that business investment and employment decisions are permanently put on hold – or businesses relocate. That is why we are not optimistic about the medium term performance of UK assets and are increasing overseas exposure at this point.

All in all, in spite of the growing influence, albeit temporary, of geopolitics, we see nothing to divert us from our central investment thesis of 2018 – that monetary policy normalisation against a background of elevated investment markets will make for a volatile and uncomfortable ride for investors for a while to come.

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