Taking Stock

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24/02/2020
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2020 has been a busy year so far for external distraction for the investor. It began on 3 January when the US assassinated Iran’s General Soleimani in a drone strike at Baghdad International Airport. This provided an early bout of volatility, mainly induced by the oil price immediately rising by around 5%, literally overnight (Source: Alpha Terminal). After considerable analysis and speculation as to what Iran would do to retaliate and what the Americans would then do, the whole issue has calmed down with both sides stepping back from the brink of war.

Just as markets were getting over that, the coronavirus arrived or at least leapt to the forefront of investors’ minds as the true scale of the outbreak became more apparent. We are still in the midst of this, but the equity markets have already moved on, comparing the mortality rate to that of SARS and have decided that the impact will be manageable. Some are of the view that this is premature and that the true impact is unknown - masked by a lack of transparency in the officially released Chinese numbers. The markets are reassured that the outbreak and epicentre of the virus is being restricted to the immediate province of Hubei with little evidence of a global pandemic. In the West, we will probably never know the true impact and what has really been happening within China. The biggest story on the coronavirus in the UK media right now is the plight of the UK nationals quarantined on the Yokohama berthed Cruise ship, the Diamond Princess, and why the UK hasn’t sent an evacuation plane to bring them home, unlike the US. Stories like this make the headlines because they make a sensational headline designed to outrage and shock but as far as investment markets are concerned, they matter very little, so long as the spread of the virus is restricted to the cruise ship, which is of course is precisely why all the passengers and crew have been quarantined on board. It does, however, highlight just how contagious the virus is, despite passengers being confined to their cabins any on board have developed the virus - which also raises the question as to just how widespread the outbreak is throughout China.

The markets know there will be an economic impact, just as there was for SARS, but this can be quantified with average anecdotal consensus forecasts of a 2% impact on annualised Chinese economic growth projections of 6% (Source: PRC).However, historic comparisons are somewhat flawed in that SARS occurred in 2003 when the Chinese economy was significantly smaller than today. In addition, the dependence of global supply chains on Chinese manufactured goods was also significantly less. The impact will reverberate around the world and have an impact on the earnings of many businesses who will run short of components in manufacturing industries, textiles in the clothing industry and high-volume retail items such as toys and electronics. Food and agricultural produce are unlikely to be affected and neither will any perishable items which cannot last the distance when packed into a container on a ship. There will be a longer lasting dip in bookings in the hotel and leisure industries, especially Asian bound cruises, the airlines and Hong Kong will be off the tourist circuit for some time having already been impacted by the free speech protests last year.

Commodity markets are not yet reeling and the oil price has not sold off significantly, perhaps because the potential for supply disruptions involving Iran remains. China is, by far, the world’s biggest consumer of basic commodities such as oil, iron ore and copper – prices have weakened somewhat but not in such a way that would suggest anything other than a short-term blip to world trade which will impact one quarter’s growth in certain industries. There is also the liquidity and stimulus lever that is part of the standard set of central bank tools these days, ever since the credit crunch when Quantitative Easing was first invented. The Chinese have already opened the liquidity floodgates and injected stimulus into their economy to shore up any businesses that run into short-term cashflow problems. This has reassured markets and the expeditious deployment two weeks ago was the principle catalyst for the equity markets to rally. There is talk of more stimulus to come and so the markets are now back in the mindset that whatever happens, the central banks of the world will come to the rescue. Not surprisingly, the bond markets have all risen as yields have fallen in anticipation of another round of global stimulus ahead, spearheaded by the Chinese authorities who badly misjudged the situation initially. Of course, with the people off the streets, there is little likelihood of any significant threat to their autocratic control system, no matter how deep the feelings may run.

Looking at the numbers, the Baltic Freight Index, which measures the capacity utilisation of bulk shipping, has taken a steep fall. This is of no surprise as Chinese exports have reduced significantly. However, the liquidity stimulus measures are offsetting this bearish indicator and supporting equity markets as we all know that easy money leads to buoyant markets, as has been the case ever since the credit crisis. The year to date performance numbers up to the close on Valentine’s Day are now telling a very familiar story from 2019. The US equity market is leading the way and in sterling terms, has risen by 6.7% (Source: FE Analytics). Next up is Europe excluding the UK which has risen by 2.1% whilst Emerging Markets and Asia-Pacific are now up by around 1% (Source: FE Analytics), despite having had a significant dip at the end of January. Japan has been flat whilst the laggard, once more, is the UK, which had been doing well as sterling rose after the General Election and some certainty returned to the political scene. This has now reversed.

Concerns are rising over the evolving Brexit trade negotiations. We have previously said that Prime Minister Johnson would enjoy a honeymoon period, in common with many newly elected Prime Ministers, and especially one with a large majority. The negotiating gauntlet is being laid down by Brussels and the markets know that the Johnson government is up for a fight and will walk away if it comes to it. We also hear that Donald Trump is making plans to put tariffs on EU car exports if Brussels don’t consider opening their markets up to US agricultural imports. The New Year tensions within the Middle East are forgotten, for now, and the coronavirus doesn’t appear to have the capacity to cause anything more than short-term supply chain disruption beyond one quarter.

The bigger issue will be an emboldened US who will consider the continued US economic expansion and Chinese malaise as a victory and take this as encouragement to deliver the same policy to the EU. This will likely be a cornerstone of President Trump’s re-election campaign. Expect to hear America First relaunched with record employment, record equity markets and a record reduction in trade deficits under President Trump’s tenure. With the wind in his sails, Brussels should be bracing itself. This has implications for asset allocation and currencies. Sterling will most likely remain weak as the heat turns up with Brussels and the possibility of a no-deal scenario returns and intensifies towards the year-end when the Brexit transition period ends. This will benefit overseas markets as, principally, US Dollar and Euro earnings are translated back into a weaker sterling. This has been the story of 2018/19 as we approached the first Brexit deadline – we now have a likely re-run of the same scenario. The UK equity market may look cheap relative to the US, but there is a very good reason why.

 

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