A NEW MOOD
2018 has been a year when investors have been reminded of economic and financial risks with damaging volatility spikes. However the year started enthusiastically, driven by synchronised global economic growth and fiscal stimulus in the US, but this mood changed in late January to early February when the market finally resigned itself to higher rates as bonds yields started to move higher. There were other worries that also came to the fore: the Italian election reminded investors that the European arena still had the capacity to unnerve as the rise of populism was far from defeated; the threat of a trade war became a reality; and growth was disappointing particularly in Europe. The enthusiasm faded and a new mood of caution took over. Nevertheless, growth continues, inflation is still well controlled, monetary policy is being tightened only gradually and fiscal easing in the US has been significant. US stocks have regained some poise since the sell-off and have significantly outperformed their global counterparts. In contrast, US bond markets have underperformed largely due to the stark difference in the trajectory of monetary policy.
This mood of caution will underpin our asset allocation given the uncertainty surrounding trade policy, European politics and Brexit negotiations.
THE KEY ISSUES:
Trade wars, tariffs and the end of globalisation
The war of words over tariffs has actually shifted towards concrete action. China and the Euro Zone have accused Donald Trump of ‘trade bullying’ as the US is seemingly set to the re-write the trade rulebook that has served the global economy (including the US) so well over the past 30 years or so. This rather toxic mood came to the fore in a remarkable G7 meeting (that ended in chaos) followed by a disruptive NATO meeting and President Trump’s controversial visit to the UK. Tariffs have been focused on China, with $34bn of Chinese imports impacted. China has retaliated but the President has now threatened to impose tariffs on the full $500bn of Chinese imports. It can’t be a coincidence that the rhetoric is stepping up ahead of crucial US mid-November elections.
At the moment, the impact of tariffs is concentrated on specific sectors that are not vital for the global economy but the move on the auto industry is far more critical. A crucial meeting is scheduled between Euro Zone and US officials to prevent a dramatic step-up that will impact some of the biggest automakers (Daimler, BMW, VW and Renault to mention some). It is bound to have a profound impact on where the production facilities will be based, through to corporate earnings and pricing of cars (this clearly matters to consumers).
Our clients always ask us the crucial questions such as, does it matter if there is an all-out trade war and if there is one, who ultimately wins?
The main risk is the disruption to global supply chains. Simply put, companies rely on parts and components from across the world and if this supply is disrupted it will slow production and raise prices for consumers. As an example, Apple sources key parts for its I-Phones from the Far East whilst also having facilities in China. Questions that will arise: Will these operations be threatened and how easily can Apple move production back to the US and source key tech components at competitive prices? Trade wars may well change well-established patterns of global trade. Globalisation has proceeded, unimpeded, for almost 30 years and this has coincided with lower tariffs. This is the first time there has been a meaningful shift towards more tariffs and fewer deals.
There is of course a difference between rhetoric and implementation. To date the direct economic impact of tariffs has been limited as these have focused on low value-added sectors. The indirect impact is more difficult to gauge and will only come to the fore in 2019 particularly if implementation is stepped up. The hope is that this will not accelerate, but clearly is an increasing risk. According to economic models, a full-blown trade war could knock US growth by 0.5% and would have an even bigger impact on Europe.
European political risk
2017 was unusually benign in terms of European political risk, but 2018 has seen considerably more turmoil. Angela Merkel’s underwhelming election performance, the rekindling of the Catalan separatist movement and finally, the triumph of populist parties in the Italian election have reminded investors that political risk still exists in Europe.
Italy is crucial as it is the third largest European economy and has the largest debt levels. While European banks did not have significant exposure to Greek debt in 2009-2010, Italy is far more engrained into the economic system of Europe and therefore the risks are magnified.
Although high, the level of Italian debt in itself is not necessarily a problem if a number of conditions are met. It is easy to forget that debt levels have been higher in the past (fairly close to today’s levels) but fell below 100% due to sustained good economic growth. However, the recent absence of sustained economic growth and low interest rates will make Italy’s position increasingly difficult. This is compounded by high youth unemployment, a narrow tax base and the postponing of crucial spending cuts. Whilst the government has said it doesn’t want to pull out of the Euro Zone, there is an uneasiness about their commitment. Given that growth is an effective way to solve youth unemployment and debt, the real question is how to put together a policy programme to allow faster economic growth whilst reducing the fiscal burden. We don’t believe the problems in Italy should precipitate the downfall of the Eurozone project in the short or medium-term unless there is a complete political breakdown.
Additionally, as we have discovered from German coalition negotiations, action on immigration/migration/refugees in Europe, although morally unpalatable, cannot simply be ignored. Underlying the political uncertainty is the need for continued economic expansion allowing the wide swathe of the populace that lost out from the financial crisis to be reintegrated and feel that the Euro Zone is working for them. Unfortunately, Euro Zone policy-makers have shown an inability in recent years to focus on the long-term and it is inevitable that there will be outbreaks of volatility and uncertainty.
Interest rate rises - a painful repricing of risk?
It took time, but US Treasuries have now repriced in response to higher interest rates. The benchmark 10-year yield rose to 3.14% and the yield curve (10-years minus the 2-year yield) flattened significantly. The US Federal Reserve (Fed) has not wavered and remains committed to a gradual rate hike path (another two this year and three or four in 2019) this forecast seems to have been well absorbed by the market and should not be as disruptive as earlier in the year. Fortunately, the Fed has continually been helped by price and wage pressures remaining steady, despite faster economic growth. The main threat to the Treasury market is now from a rather unlikely source; President Trump undermining the independence of the Central Bank through inappropriate comments on monetary policy. This is the first time in almost three decades that such an intervention has occurred and it is hoped that his economic advisors will persuade him to desist from further comments. If he steps up his rhetoric and the market concludes that the Fed may be compelled to tolerate higher inflation and its independence is compromised, a more significant sell-off in Treasuries may be triggered (most likely a steepening yield curve).
A risk that is increasingly getting air time is that rising interest rates in a more leveraged economy will threaten companies’ refinancing. The fear is that companies will not be able to withstand the impact of higher rates causing default rates to rise, leading to a new recession. We are certainly not complacent about refinancing risks but also acknowledge that companies have been far better at re-engineering their balance sheets with far longer maturities (i.e. less short-term financing risk), holding more cash on their balance sheets (better cash-flow coverage for coupon payments) and have kept overall leverage under control (debt as a ratio of earnings has not ballooned). This is not to argue that there will be no impact on credit spreads from rising rates but it is unlikely to trigger the “debt mountain crisis” intimated by market commentators. We are continually monitoring the various sectors that we have invested in and will shift asset allocation appropriately.
In stark contrast to the US, there is no question mark over whether the ECB is sticking to its dual approach of ending direct QE (asset purchases in the final quarter) whilst providing clear forward guidance that rates will remain unchanged late into 2019. It has voiced concerns over trade wars and if trade wars step-up, the market will most likely delay rate hikes into 2020 and may yet extend Quantitative Easing (QE) into next year.
End of a mature economic cycle – is recession inevitable?
It is true that all economic cycles must end. This cycle has been long, and interest rate rises have often been the trigger for recession. However, the end may not come suddenly if there is no exogenous shock – an all-out trade war or a financial crash. For the time being, we see the threat of a hard landing type scenario as unlikely. It is likely that US tax cuts and the greater buoyancy in the Indian and Chinese economies can prolong the cycle well into 2019. However, a slow-down and a mild recession is inevitable as consumers retrench, companies cut back on spending and the labour market turns.
More interesting to us is the likely response of policy-makers. It is likely that any threat of a significant recession could mean a complete reversal in monetary policy with QE and interest rate cuts. This is not a rallying call to embrace risk assets, rather to be selective when picking assets. While financial markets have been very focused on the risks this year – trade wars, Brexit, European political problems, their core policies remain undisturbed.