The UK stock market finished an eventful third quarter broadly unchanged, though global equities were able to post impressive gains. Beneath this strong aggregate showing, however, there has been stark divergence in regional performance, with the US once again doing the heavy lifting. After the ‘global synchronised recovery’ of 2018, evidence continues to emerge that the world is now travelling at many different speeds. A resolution to this imbalance, as with nearly all financial discussion, lies with the dollar.
Standing on the Shoulders of Giants
The US economy, whose recovery was already outstripping that of any other developed nation, has been further bolstered by the very generous fiscal agenda of the Trump administration. Tax cuts have stolen the headlines, but stimulus has also arrived in the form of increased spending, in areas such as defence and welfare. This more expansive approach has helped deliver a marked acceleration in both economic growth and stock market earnings, but also in the level of government borrowing. To date the investment community has been most focused on the boost to growth, noting the confidence this has given the US Federal reserve to lift interest rates off their emergency lows. Such ‘tightening’ measures are months, if not years away from the thoughts of the other major central banks, however, with many still grappling with how to terminate their quantitative easing programs. This divergence in economic performance, and consequential policy settings, has proven a potent cocktail for the dollar, moving to 12-month highs during the quarter.
It should be noted, however, that in September, despite further releases of impressive US economic data, which served to build conviction in the Federal Reserve’s interest rate intentions, that the dollar weakened. This is a reminder that it often takes ‘exceptional’ events or data to attract or repel capital, and in so doing, move prices. It might also reflect the market’s nagging concerns about the amount of dollars the US government is having to borrow to fund its current fiscal agenda; with international lenders demanding some kind of discount in the greenback for its troubles. But with only a solitary month of data to support the suggestion that US economic performance is having a diminished role in the fortunes of the dollar, it is perhaps a little too early to call for its secular decline; but it’s certainly one of the key calls to be made in the coming months and years.
I need a dollar, a dollar; a dollar is what I need
The importance of the dollar was no better demonstrated than by the strain it placed on Emerging Market assets, economies and, ultimately, policy makers over the period. Though Emerging Markets is a broad church, capturing diverse economies at various different stages of economic development, as an investment group it is apparent that a significant amount of dollar borrowing has been used to fund expansion plans. During periods of dollar strength, therefore, a higher proportion of local currency revenues are channelled towards servicing debt rather than more growth enhancing endeavours. And in textbook fashion, Argentina and Turkey endured heavy selling over the third quarter as their ability to service significant levels of dollar denominated debt was called into question.
In an attempt to defend domestic currencies against a precipitous currency devaluation, central banks can choose to raise interest rates, boosting the returns on offer for international lenders. The upshot of this strategy, however, is that it also raises the cost of funding for domestic borrowers, acting as a brake on growth. It can soon become an impossible balancing act to stave off both an assault on the currency and an economic downturn. Indeed, such occurrences most typically culminate in a recession as independent central banks, in keeping with their mandate, hike interest rates to combat the inflationary risks brought on by a weaker currency. Execution of such an economically conservative approach is, however, less apparent in areas of reduced central bank independence. As we saw in Turkey, despite ongoing currency weakness, President Erdogan leaned into policy makers to prevent a dramatic hike in interest rates, fearing the consequences for growth. Such indecisive steps are given short-shrift by investors, however, and as the currency came under ever greater pressure, so the President was forced accept the necessary course of action, allowing the central bank to be far more assertive in raising interest rates. Such a move will likely trigger a sharp slowdown in domestic demand but will also reduce the level of dollar borrowing required to fund previously elevated levels of activity. The correction of these imbalances are a necessary step to reduce the vulnerability to similar currency attacks in the future, but are no guarantee. Argentina has attempted to take all the necessary steps to rebalance its economy, but as reform has been a little slower than preferred the currency has still taken a thumping. It maybe that some economies have just gorged on too much cheap funding for too long and a crisis is the only way out.
Early in the quarter, at a pivotal meeting at the UK Prime Minster’s country retreat, Chequers, the cabinet arrived at a comprise arrangement on how to take Brexit forward. The proposed deal, known as the Chequers Plan, at first declared harmony among the diametrically opposed elements of the cabinet, but before the ink had dried the resignations had begun. The deal, which would seek regulatory alignment with the European Union in order to keep existing relationships as frictionless as possible, has been under fire from both ends of the Brexit spectrum. Leavers dismay at the limited capacity the proposal offers to sign significant new trade deals, whilst both Remainers and Leavers balk at the idea of following EU regulations while having had little to no say in their formulation. Its first airing at the European Commission was met with an equally unenthusiastic response, particularly over the requirement that the UK collect tariffs on behalf of the EU. As things stands there is little momentum behind the Chequers proposal and much more building towards a Canada style arrangement. This approach brings its own complications, however, not least on how to resolve the requirement for more vigorous customs checks, when it is the ambitions of all parties to avoid the increased presence of personnel or infrastructure at the Irish border.
The challenges of a securing a bespoke arrangement, combined with the political obstacles, have raised the prospect of a ‘No Deal’ Brexit (from a low to a moderate possibility). Indeed, creating an atmosphere of tolerance to a No Deal may have been an intention of the UK government, in order to extract more concessions from a ‘nervous’ European Commission. Shorter-term risks to the UK economy would be elevated under a No Deal Brexit, meaning the government’s more assertive approach has contributed to a weakening of the pound over the quarter. Sterling’s performance did improve over the second half of the period, however, as not only did the dollar weaken, but UK jobs and general economic data continued to show resilience. The currency’s cheapness will have also played a part.
The Art of the Deal
The Trump administration has showcased a degree of pragmatism in recent months securing trade deals with Korea, Mexico and, at the 11th hour, Canada. But despite this good news, there was only escalation in the Sino/US trade discussions. US authorities levied tariffs of 10% on an additional $200bn of Chinese imports in September, implementing a ratcheting mechanism that will take the tariff to 25% in the coming months. This will prompt companies to front load their orders to escape the higher tariffs of 2019, distorting their apparent impact over the coming months. Trade tensions therefore, are likely to serve as a headwind to Chinese growth, although, in typical Chinese fashion, will be partly mitigated by State directed stimulus.
Longer term investors might actually take some comfort from the more stubborn approach the Trump administration is taking to Chinese negotiations. Fighting for the security of intellectual property is a noble endeavour, especially for those economies involved in advanced stages of research and development, such as our own. We should also, perhaps, be relieved someone is standing up for America, after all…
"I think if this country gets any kinder or gentler, it's literally going to cease to exist."Donald Trump, March 1990
Ben Gutteridge, Head of Fund Research