The Weekly: Living for Today in the US of A

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22/10/2018
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When parliament has descended into a Brexit squabble with personal insults and worse, it is time to stand back and take a deep breath. This illustrates how emotional the whole debate has become, and unfortunately we are not there yet, or maybe the quoted 95% really does mean that we nearly are. More likely, it is a mechanism designed to shut up the naysayers, sending the message that if you continue to criticise the process and the progress, you could well have egg on your face very shortly. Delivering problems and throwing rocks is the easiest thing to do but few suggest credible solutions, despite having full knowledge of what has already been rejected. You have to feel sorry for Theresa May but perhaps that is her strongest card in that nobody wants her job just yet. If she extends the transition period, she potentially extends her premiership.

The problem in a nutshell is that people voted for a variety of emotive reasons, as they do at every election. However, at an election, it is decided on political ideology, personalities and a selfish personal view on which administration will make you better off. With Brexit, which was a binary question, nobody knew or knows even now whether they will benefit. Hence the close referendum result, the current anxiety and now the emotion depending on how your employment is likely to be affected. We all want to know the outcome so we can get on with our lives and adapt to whatever transpires, with the waiting being the most excruciating part. At least Prince Harry and Meghan have managed to briefly change the headlines over the weekend onto more positive news!

Moving on from Brexit because we can add little at this stage, we have seen some sort of rally in the Chinese equity market over the last few days, following the sharp falls which followed Trump’s tariff wars. The investment environment really was getting very dark last week, whether it was Brexit in the UK, Italy in the EU or Trump’s usual variety of weekly threats which involved Saudi Arabian sanctions, extracting the US from Russian nuclear deals or more Chinese tariffs. There is a point where the market seems to say ‘enough is enough’ on the downside and then momentum kicks in and the buyers come back. This is the reverse of what we saw earlier in the month where the negatives seem to suddenly overwhelm the bulls, leading to the sell-off.  Now the same negatives and a few more, following the subsequent falls, seem to be energising the bulls to say ‘enough is enough, there are some decent quarterly results coming out of the US, let’s remind ourselves what we invest in, there are some bargains out there’. Such is human psychological behaviour and the madness of crowds.

Meanwhile, the US mid-term elections are creeping up on 6th November and causing a frenzy of speculation in the US. We cannot recall a time historically when so many non-US citizens have been so focused on the result. This will be the result of seeing whether one of the most outspoken and bombastic Presidents gets a bloody nose, which many would enjoy. One thing about the British psyche is that we hate outspoken, self-congratulatory behaviour, preferring reserved self-deprecation, finding the former somewhat vulgar. It is quite possible he will lose the lower House of Representatives to the Democrats whilst the higher Senate is probably secure. In the UK, we only normally get the chance every five years to make a change, although many voters are increasingly cynical about the whole process, hence the rise of historically peripheral radical alternatives. We should see the emergence of a new political ideology coming out of the ashes of the centre left and right incumbents, but this is yet to be seen in the UK. Perhaps we will have to endure a more radical administration in the interim to reinvent a new middle ground.

The mere fact that the US economy appears to continue to cook on gas is reassuring so far as this is the primary prop to world growth and stable markets. Trump is certainly kicking the foundation pillars with his tariffs and tax cuts, potentially fuelling inflation with both. It comes with some relief that the Federal Reserve is not flinching from Trump criticism which has been universally condemned by global financial heads. But then Trump has to line someone up as the fall guy when his economic miracle starts to lose its lustre.  Any administration in the world, if they have the firepower, can cut taxes, hike spending and win voter support as GDP temporarily surges. It is the aftermath of a burgeoning budget deficit when tax receipts have plummeted that comes home to roost such that a period of austerity is required to fill the financial black hole.

Trump believes in the Laffer Curve. This was developed by Arthur Laffer in 1974 and is based on the premise that as taxes rise, less revenue is generated over time, as entrepreneurial risk is stifled. Of course, this depends on what is being taxed and the elasticity or change in demand as taxes rise. This is why, in the UK, we all suffer from heavy tax on car fuel, because we all have to drive, and the same goes for alcohol and cigarettes. Consumers have to pay it and so the proportion of tax built into the end price is very high. However, income tax is an entirely different matter whereby if very high taxes are introduced on high earners, they will seek out ways to avoid it and the tax take actually falls. We have seen this recently with capital gains tax rules whereby the rate payable has fallen significantly from the marginal rate of income tax to one of two much lower rates. Consequently, individuals are more likely to pay it and the tax take actually rises. For the Treasury, 20% of something is better than 40% of nothing!

In the land of Trump, he believes that if you cut corporation tax from 35% to 21%, as he has done, then the subsequent reduction in the exchequer corporation tax receipts of 40%, which is a huge number, will be ultimately offset by higher receipts as the lower rate of 21% will be based on a much bigger economy as growth surges. In fact, for that to occur, ignoring the other income tax cuts and spending commitments that he has made, then the US corporate economy will have to increase by two-thirds for the same tax receipts to be realised. Spread that over ten years and you would need an economic uplift of over 5% a year to recoup it back. It also assumes that companies reinvest the benefit of the tax cut into their business, with enhanced employment and productivity. There is an element of job creation going on but as the US economy is at full employment, this is difficult to achieve. The reality is that many companies are using the tax windfall to buy-back even more of their shares from the equity market. So don’t expect this US market sell-off to last for that long whilst corporate coffers are swelled.

The bigger worry is what happens after Trump has finished his term in Congress, whether that be for a further two years or six years. Neither is long enough for us to fully appreciate whether Laffer was correct or whether the dramatic tax cuts have moved the US onto the optimum point of the so-called Laffer curve, the peak of which is the optimum combination of tax rates and tax take spurred by resultant stronger economic growth. For now, we know the US economy is getting a massive shot in the arm, the voter is getting a boost to take home pay and growth is peaking at 4% per annum, with inflation subdued and interest rates normalising towards 3.5%. It looks like the holy grail of capitalist economics. However, if the Laffer assumptions above are borne out, the US budget deficit is going to balloon and the next administration is going to have to sort out the mess.

The US is very much living for today, as is Donald Trump, with little preparation for whatever tomorrow brings. In fact, we doubt whether his political strategy looks forward much more than the next election, such is his quest for re-election. His slogan should actually be Trump First and not America First because the current economic fruits of largesse cannot possibly last. In the UK, capitalist governments tend to cut taxes and cut spending whilst socialist governments tend to increase taxes and increase spending. Trump is cutting taxes and increasing spending – surely a recipe for trouble for tomorrow.

 

Chinese Equities Slump to Four Year Low on Trade Concerns

The Shanghai Composite Index (SSE) fell to its lowest level for nearly four years last week (1) as concerns over trade tensions with the US and weak economic data continued to dent investor sentiment. With the Yuan continuing its downwards trajectory against the Dollar, the SSE slipped to its weakest position since late 2014 on Thursday with the fall prompting further intervention by the Chinese Government in an attempt to reassure investors.

Elsewhere, developed world equity markets had a largely uneventful time after the previous week’s major sell-off. UK markets were mixed with the large cap, international focussed FTSE100 gained +0.8% and the more domestic centric FTSE250 declined -0.9%. Eurozone equities also endured a mixed week as the Euro STOXX 600 posted a steady gain of +0.6%. Volatility remained prevalent in the US, despite some strong earnings results with the S&P500, ultimately closing the week flat.  Japanese stocks remained on the back foot with a weekly loss of -0.7%.

In the sovereign debt markets, US Treasury yields resumed their upwards trajectory after the previous week’s decline, rising by 4 basis points (bps) to 3.20%. Italian 10-year yields were also on the rise, hitting 3.73% which is the highest for four years after further issues with the Government’s budget (2). The domestic equivalent gilt yield was 8bps lower at 1.56%.

Sterling came under selling pressure as concerns regarding a ‘no-deal Brexit’ scenario continued to gather momentum. It declined by -0.9% against the Dollar and -0.3% against the Euro to close the week at $1.304 and €1.135 respectively. It proved to be a decent week for the US Dollar which rallied against each of its major peers from around the world.

Higher than expected inventory build left oil prices lower with US crude stocks rising by 6.5m barrels, the fourth straight weekly build (3). Brent declined by -0.8% to take it back below $80.00 a barrel. Meanwhile, Gold continued its strong start to the month with a +0.6% increase. The precious metal closed the week at $1226.52 an ounce.

 

Source: Financial Times 2018 (1)

Source: T. Rowe Price 2018 (2)

Source: OilPrice.com 2018 (3)

Source: Unless stated, all other data comes from Thomson Reuters DataStream

 

Week Ahead

The important data release of the week arrives on Friday as the US releases its first calculation of Q3’18 GDP. A slowdown is expected on the lofty +4.2% quarterly growth delivered in Q2 although the +3.3% forecast is still impressive, boosted once again by the substantial fiscal stimulus implemented earlier in the year. The Federal Reserve releases its bimonthly ‘Beige Book’ on Wednesday, with all 12 Federal districts providing an update on their respective economic conditions over the last 2 months. In the Eurozone, the ECB hosts its latest policy meeting on Thursday. No changes to interest rates are expected once again, with President Mario Draghi set to host a post meeting conference during the afternoon. Tomorrow’s PMI figures are the main data to keep an eye on. In Japan, focus once again falls on inflation (or rather the lack of!) with the Bank of Japan’s core calculation due tomorrow. Domestic and Chinese data is limited on this occasion.