Vista - The outlook

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07/08/2019
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I make no apology for the fact that this edition’s Quarterly Outlook will focus very much on the UK political environment. With the advent and outcome of the Conservative Party leadership contest, the long-running Brexit saga looks to have entered a new and potentially decisive (or dangerous) phase. The ramifications and likely scenarios are discussed later. But we are able to do so because it’s not too difficult to explain market moves in the rest of the world, which have been rather muted in the second quarter. Not that there hasn’t been much going on – on the contrary, some developments have been extraordinary, but the two powerful influences upon market direction have, at least in respect of equity market behaviour, been largely offsetting.

On the one hand there has been the continuing deterioration of the economic indicators, both the coincident indicators (for example the Chinese economy growing at its slowest rate for many years) and the forward-looking indicators – of which the most telling have been the various Purchasing Managers Indices (PMIs) in most of the major economies. Some slowdown was of course inevitable, following the surge induced by US fiscal loosening last year, but the deterioration has been marked. In some cases, for instance Germany, this seems to presage outright recession. The IMF reduced its 2019 global GDP forecast in its April “World Economic Outlook” and has just reduced it further in its July update. 

US/China trade dispute

Of course, what hasn’t helped this perception is the escalation of the US/China trade dispute in May. That the US imposed 25% tariffs on $250bn of Chinese exports to the US is bad enough (and China retaliated with 20% tariffs on $110bn of US exports to China). But the fact that these were announced on Twitter at precisely the time of ongoing negotiations with the Chinese is not what one expects of serious negotiations conducted between economic superpowers. Markets sold off around this time. These tariffs are having an impact in Asia and also on some sectors of the US domestic economy, a point which the IMF has explicitly acknowledged. Of course, a truce of sorts was reached at the G20 meeting at the end of the quarter, but the concerning thing about these events is that it does reflect a struggle for economic hegemony which is not going to go away. This is one area of US policy where the Democrats are aligned with what Trump is trying to do.

However, although markets were shocked at the imposition of tariffs, they quickly jumped to the conclusion that there would be an offsetting policy response from the World’s Central Banks. If you remember, last quarter saw an amazing reversal in sentiment about the future course of short-term interest rates, mostly in the US but also elsewhere. Expectations turned from a number of increases in short rates to rates being on hold or even being reduced. The second quarter continued the trend such that market participants began to expect two or even three reductions in interest rates in the US as the economic environment deteriorated. This shift was enough to drive bond yields, which are simply echoing the markets’ views, down to levels last reached in 2016, such that, once again, a large proportion of global sovereign issuance is trading at negative yields.

Market sentiment

I’ve mentioned before that it is a good thing that market sentiment is reflected in surveys and, to an extent, in valuations that are “normal” (whatever that is nowadays). The whipsawing of markets reflects, above all, uncertainty about policymakers’ priorities; the poor level of sentiment, I’d argue, reflects doubts about the effectiveness of policymaker actions going forward. There is no doubt that the World’s Central Banks would like to move interest rates higher. They are obsessed by the notion that, in the event of renewed recession, they have very little firepower left to tackle it. But the periodic bouts of softness to which the economy is susceptible give them no confidence that they can do this. What they would dearly like, of course, is some degree of support from national fiscal policy. But the continuing high level of sovereign indebtedness seems effectively to preclude that. Markets see policymaking as a one-trick monetary pony and don’t really like what they see.

Is there a no-deal Brexit ahead? 

To put the UK into this backdrop offers very little comfort. I think a few things have changed since Mrs May resigned, besides the inevitable accession of Boris Johnson. First, we now have a Prime Minister who apparently is far more committed to a no-deal (ND) Brexit than she ever was.  Secondly, there is a sense that the October 31st deadline is rather more of a drop-dead date than March 31st ever was, not least because of the attitude of hardliners in the EU.  Third, the Labour party has shifted, meaningfully but not fully, towards supporting Remain.  

The impact of these developments is to make the possibility of ND later this year higher than it was; I still think it most probable that it won’t happen – because of the declared opposition in Parliament. But the fact that Boris has declared for Brexit “do or die” by that date does mean that even he would find it difficult to carry on and ask for an extension as May has done. Which means that some referral of the Brexit issue to the court of public opinion sooner rather than later becomes much more likely, be that a General Election or a Referendum.  This implies that the stance of the Labour Party in that process becomes more important.  

There are some fundamental questions for the Boris premiership to answer. Some people say (and hope) that the most important one of all is which of his promises does he choose to break? He has vowed to complete Brexit by the deadline, not to give way on the backstop, not to hold a Referendum nor to have an Election. At least one of these will have to go, not least because he’s got one of the smallest majorities in history.  

The one hope of delivering Brexit, I think, is if some very small amendments to the Backstop can be negotiated, then the PM might be able to get support for a slightly changed version of May’s Withdrawal Agreement to go through Parliament, particularly if he can bring around some Labour Leavers. He might just be able to do this – after all, if he is so confident of implementing the technology eventually to implement Brexit without creating a hard border in Ireland, why not agree to the backstop in the full knowledge that its insurance policy will not be required.

However, if Labour really has become the Remainer party, then it should oppose this development and vote down the Government, while campaigning energetically for Remain in the following election. There is a distinct possibility that such a shift could persuade people to disregard some of the less salubrious aspects of the party, such as the heavily socialist agenda and its institutional anti-Semitism, particularly with an effective marketing campaign. For now, Corbyn is resisting the full extent of this shift to Remain. But there must be a good chance that he is persuaded (against the better judgement of his immediate advisers) and, if so, Labour becomes electable in its own right.

On the other hand, if an election were to happen soon and the political parties’ platforms were to remain broadly unchanged, the only certainty would be that it would be an extraordinarily confused election. It is difficult to see how Tories such as Philip Hammond and Rory Stuart could fight on the same manifesto as Jacob Rees-Mogg. The only thing that unites them is fear of Corbyn. In which case, the Tory vote would be divided and decimated and the likely outcome would probably be a Labour/SNP/LibDem coalition. This may not be a bad outcome – it would probably not end the Brexit uncertainty, but might soften the more radical and extreme ideas of the Labour left.

But I do now think that the outcome of the ongoing Brexit debate is probably of less importance to markets than the composition of the Government that takes us through it. 

This is not an encouraging picture, not least because it points to continuing uncertainty and the possibility of binary outcomes. In these circumstances, the best investment policy is to stay cautious and well-diversified. 

Past performance is not indicative of future performance.