Vista - The outlook

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26/02/2019
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2018 was not a good year for financial markets.  The major equity market blocs (UK, Europe, US, Asia and Emerging) all registered negative returns in sterling terms in the calendar year.  UK Gilts struggled to break even and cash gave the sort of measly return we have come to expect from cash in the last ten years, ie not a lot. The standout performer for much of the year appeared to be UK commercial property and the IPD index, the bellwether index for institutional portfolios in the UK, which registered a positive return officially.  But even that was distorted by exceptional returns from the industrial logistics sector while UK offices (Brexit) and shops (continuing troubles on the High Street) didn’t do nearly so well, so most bricks and mortar and security funds did less well than this.

As you will know from previous Outlooks, we were not surprised by this outcome.  We have argued for a while now that financial markets had been artificially buoyed up by central bank liquidity injections. As these were withdrawn and interest rates rose, weaker and more volatile conditions were likely, although, to be honest, given that the extent of the liquidity injection was unprecedented, how markets might react to their withdrawal would be a step into the unknown. 


And indeed, 2018 saw this change of approach happen in earnest.  The US Federal Reserve, in spite of the opposition of President Trump, raised rates 4 times, the latest in December.  The Bank of England also raised rates, and, undoubtedly influenced by fears about the potential impact of Brexit, announced it will start to wind down quantitative easing once rates reach 1.5%.  Also the European Central Bank announced it will cease its Asset Purchase Programme early in the New Year.


The immediate impact of this was upon sovereign bond markets, about which we have been cautious for some time.   But it also had a dampening effect upon equity markets.

The changing trend for interest rates has been obvious for a while.   But it took the escalation of America’s tariff and trade dispute with China to really spook global markets in the Autumn.  Emerging markets and Asia had been concerned about this for some time.  But its escalation and the realisation that it could be quite damaging to the US Tech sector in particular were the catalyst for a more broadly based correction that saw the US market record serious underperformance in the fourth quarter.  Apple Inc recorded a market capitalisation of $1.06trillion in September – by the start of the year it had fallen to $733million, a fall of 30%.


I remarked at the start of the fourth quarter that as long as these two major trends – monetary tightening and trade tensions – looked set to continue, it was difficult to envisage markets making progress.  But I now feel more optimistic than I have for some time about world markets – I say more optimistic but that does not mean outrageously positive.  I still believe equities will struggle to make meaningful progress in coming months.  Partly this reflects a UK bias clouded by prospects for Brexit – for more of which see later.  Partly it is because, while there are signs that deals may be done to avert an outright trade war between China and the US, this will take time and it remains the case that the hawks in the US administration are determined to do China real damage.  In addition, it looks as if the world economy is slowing down and that momentum is meaningfully negative.  But this relative optimism is the result of two factors – firstly, equity valuations following recent falls look more compelling than they have for some time.  Secondly, and more interestingly, there may be good reasons why the pace of monetary tightening might pause.


The first of these is that the global economy appears to be slowing.  The most consistent region continues to be the US, which is still benefitting, albeit now to a reducing extent, from the Trump tax cuts implemented last year.  Elsewhere, however, in China, Europe and not least the UK, momentum seems to be declining.  In these circumstances, one might question the need for higher interest rates.  The most recent monthly update by the OECD of its wide-ranging clutch of composite leading activity indicators points in the same “dovish” direction as far as future monetary policy is concerned.


The other, more fundamental reason is the curious behaviour of inflation.  In the developed world, it has kept remarkably low, in spite of the massive expansion in the monetary base and in spite of the very low level of unemployment – both factors thought to be strongly associated with higher inflation in the past.   So, for example, the US inflation rate has been below the Federal Reserve’s 2% target since 2012! Much ink has been spilt finding reasons why, which will be the subject of another article.  But it does mean that as long as this phenomenon persists, and there are no indications to the contrary, there isn’t the same need to raise interest rates as before.  Indeed, Central Banks might legitimately conclude that they reverse special quantitative measures – by selling assets back to the private sector – before raising rates.


No Outlook would be complete without some commentary on Brexit.  As I write this, Parliament is in recess, so at least the news programmes are a little less Brexit-obsessed. However, recent events do not show our political masters in the best possible light. So we now have the bizarre spectacle of a Government spending billions putting in place contingency arrangements for a crash Brexit while homeless people are dying on the streets outside Parliament.  All in the hope that the threat of a no-deal will bring MPs to heel and allow the meaningful vote to proceed.  This is political blackmail on an unbelievable scale, threatening a disaster which could be averted very easily by cancelling article 50.  No wonder business leaders are becoming increasingly vociferous in their protests.

I still believe a no-deal is quite unlikely, not least because there are rumours of cross-party alliances being formed to thwart it if it became a serious possibility.  Those alliances should have been formed months ago but the party system is so broken and the respective leaders so one-dimensional that it hasn’t happened, at least not openly. 


For most sensible people, Brexit should be seen as involving compromise, most fundamentally between its impact on national income and its potential to restore “control” over our future governance (courts, immigration etc).  The realists contend that you can’t “have your cake and eat it”, that enhancing the future control dimension will involve some cost to national income.  It’s not clear whether Prime Minister May’s plan will enhance or damage the control axis but in her eyes it minimises the hit to national income from leaving the EU. In that sense it is relatively “efficient”. Let’s be clear, the EU, the counterpart to the negotiations, believes very strongly in this trade-off - that exit has to incur cost.


Given these entrenched attitudes and the inflexibility of the party system, a new referendum is now looking the clear favourite outcome. It would have to be combined with Article 50 suspension or an agreed delay from the EU.  I think UK financial markets would initially react positively to such a development, but possibly not for long as the debates about its design, let alone its outcome, stretched on.


Whatever happens over the coming months, do not think for a moment that March 29th will see an end to this affair.  I predict that the UK’s relationship with Europe will continue to be a divisive and cancerous issue in British politics for some time to come.  Argument about this issue has already fundamentally impaired our ability and willingness to deal with other pressing problems in our society.