The Weekly: A rock and a hard place

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26/11/2018
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Our Prime Minister’s attempts to promote her Brexit deal make King Canute look optimistic. Theresa May continues to believe she can defy the oncoming tide of Commons defeat but then again, she has no choice but to continue the fight for that outcome. If defeated, she may decide to consider her position, depending on the interpretation of her prediction of the resulting ‘division and uncertainty’. We will see.

We highlighted last week that the backstop was effectively an insurance policy for the EU, not the UK, and this favouritism could result in Boris Johnson’s prediction of a vassal state becoming reality. Spain’s desire to link the future trade negotiations to the sovereignty of the Rock of Gibraltar gave the impression that the negotiations were indeed tough. However, the speed and ease with which this emotional protestation was solved on Saturday suggests stage management in support of Theresa May back home. Subsequent to this, though, President Macron has now sewn the seed of fishing rights and the potential of the backstop being used to beat the UK over the head, as we always thought. This is why some Brexiteers have said that the withdrawal agreement and its backstop can be used as blackmail by the EU and does nothing to help the UK in its trade negotiations, rather the opposite.

Whether you’re a Remainer, Brexiteer, DUP, SNP or a Labour supporter, when the French and the Spanish start humiliating the UK, many UK nationals adopt a hardened position, and this is before Germany has started, which is highly likely to cause more sensitivity. The likelihood of this deal causing significant acrimony between the UK and many of its EU neighbours is almost guaranteed, and Spain linking trade discussions with the UK’s sovereignty over Gibraltar will be too hard to swallow for most.  We will see how the rhetoric develops, but we fear that the days of Theresa May could be numbered and the fact that she is openly supporting such a position goes a long way to explain the resignations we have seen.

So, from here we are staring at a ‘no deal’ scenario or a renewed referendum in the face, unless we see the biggest Commons capitulation ever. Very few, apart from the hardest Brexiteers will have the stomach for ‘no deal’, especially if they are mindful of the reaction in their constituency and every business that may be affected. As for a renewed referendum, that is difficult to envisage with Theresa May in charge, especially with her having previously said this was out of the question. Her resignation is the last thing we need and the fact that the 1922 Committee cannot muster the votes for a no-confidence vote suggests that most of the government are of the same view.

For now, the UK equity market appears relaxed, with sterling a little weaker but with no sense of impending constitutional crisis. Although the argument against holding a second referendum and faux democracy is sound, if parliament votes against the deal and the EU will not renegotiate and then Theresa May goes, effectively our elected leaders have failed us all in delivering a Brexit outcome. Say we do have another referendum, what if it returns a repeat decision to leave the EU? What then? These are historic times which require strong leadership but right now, this is difficult with such a weak governing majority.

Moving on more generally, the markets are currently treading water and going nowhere, with much of the rest of the world already underweight to the UK equity market as a result of the Brexit process. Concerns further afield are more to do with evidence regarding a slowdown in global growth and early signs that Trump’s tariffs are starting to affect global trade and company profitability. The forthcoming G20 meeting in Buenos Aires was raising expectations that the US and China could agree a deal to end the tariff war, but an apparent fall-out between Vice-President Mike Pence and the Chinese delegation in Papua New Guinea at the Asia-Pacific Economic Cooperation earlier this month has lowered expectation, if not eliminated it. We live in fractious times.

Investor nerves are certainly being tested to the maximum, but is the resilience misguided or rational? We believe the latter because the forward-looking economic indicators are largely positive, although we acknowledge a weakening over the summer. Recessions normally occur due to some significant economic shock from a crisis, or they follow a period of exceptional growth, after which the brakes must have to be put on via interest rates due to resurgent inflation. Neither of these scenarios are present, with reducing or record low unemployment, and stable or growing profits in most developed economies. For now, there is no suggestion of inflation getting out of control nor a need for interest rates to suddenly rise.

We foresee a period of stagnation into the New Year, with 2018 delivering negligible returns in this uncertain and politically charged environment, which is affecting long-term business investment. The froth in the US social media stocks has blown away with the so-called FANG stocks retreating by around 20%. So, the hottest areas are in bear market territory whilst many other markets qualify as having endured a correction being a 10% fall. Whilst disappointing, with US corporate profits remaining robust, there is no justification for further falls from here. That said, if Trump were to spectacularly fall out with China or the UK Brexit experience becomes a full-blown constitutional crisis, then we would revise that assumption! But, even the latter scenario, which would result in significant sterling weakness, does not necessarily mean UK equity market weakness due to the usual currency translation arguments.

Our advice is to keep calm and keep the hysterical media in perspective – it is their job to sensationalise a story. Remember what we invest in - profits, balance sheets and dividends - not political crises.

 

Tech Rout continues as S&P turns negative for the year

The FAANG stocks (Facebook, Apple, Amazon, Netflix and Google parent Alphabet) entered bear market territory last week as global equity indices continued to struggle. The major tech names, where extremely high multiples is common place, have all endured a tough time over the last few months with the FAANG names all falling more than -20.0% from their recent highs (1). Consequently, the S&P500 which had been the standout major equity market in recent times, is now in negative territory for the year and the index fell by a further -3.8% last week (2).

Elsewhere in equity markets, the FTSE100 continued its recent descent, dropping by another -0.9% with the mid-cap focussed FTSE250 -0.3% lower (2). Further down the market cap spectrum, the FTSE AIM index has come under considerable selling pressure recently with last week’s -3.6% fall, leaving it more than -15.0% down over the last 3 months (2). In Europe, the German DAC30 and French CAC40 closed the week -1.3% and -1.6% lower respectively whilst in Japan, the Nikkei was broadly flat (2).

Despite the volatility being seen across the equity space, sovereign bond yields had a largely uneventful week. 10-year Gilt yields were 4 basis points (bps) lower at 1.38% whilst the American Treasury equivalent declined by 2bps to 3.06% (2).

In the commodity markets, oil maintained its recent slide with Brent dropping below the $60.00 a barrel mark. Last weeks near -12.0% decline left it at $58.80 after Saudi production levels continued to rise (2). The slump in price will no doubt be welcome news for President Trump who has been pushing for higher output (and subsequently lower prices) to keep his voting base at home happy. In other commodity related news, Gold continued to creep higher, this time by +0.2% to $1,223 an ounce (2). Whilst equity markets have fallen out of bed over the last 2 months, the precious metal has held firm.

 

T. Rowe Price (1)

Thomson Reuters DataStream (2)

 

Week Ahead

In what is a relatively data light week, domestic focus is likely to be on the Bank of England as it releases the results from its latest banking sector stress tests. They will form part of the BoE’s Financial Stability Report which is also due on Wednesday morning. Across the Channel, Eurozone inflation and unemployment figures are due on Friday with both forecast to have dropped by 10bps to 2.1% and 8.0% respectively (1). Recent macro data for the region has been largely disappointing so a positive surprise for either number will be welcome news for the policy makers at the ECB. In the US, Wednesday brings a revised Q3’18 GDP number, which if the forecasters are accurate will reveal slightly faster growth than previously estimated (+3.6% vs +3.5% previously) (1). Meanwhile, the Federal Reserve releases the minutes from its most recent FOMC meeting on Thursday. In China, official PMI figures for the Manufacturing and Services sectors are published on Friday whilst in Japan, there are a number of headline indicators to keep an eye on, including unemployment, retail sales and industrial production.

 

Forex Factory 2018 (1)