Outside of the Korean Peninsula it’s hard to spot good news stories in the global and financial media coverage. Whether it’s escalating trade tensions between the world’s superpowers, a radical Italian government or a stuttering Brexit, there seems no let up in the flow of destabilising news. And yet, after a punishing first quarter for stocks, markets enjoyed a resurgence in the second quarter lifting global and domestic equities back into positive territory for the year.
The most crucial lesson to be drawn from this period, therefore, is that whilst news flow can impact decision making for shorter term investors, injecting some volatility into markets, it’s hard to keep stocks down unless recessionary risks become elevated. And whilst on the surface there are plenty of things to make us nervous, the odds of a recession in the next 12 months look modest. There is clear evidence of a slowdown in Europe but, at this stage, data points to a return to trend growth following the surge in 2017 performance, rather than anything precipitous. The news is even better in the US where growth is reaccelerating in response to the cuts in corporation and income taxes. On that basis the market recovery has been a rational move.
Of course, there remain plenty of challenges for investors to deal with, and those following share prices more closely will have noticed the final weeks of June have brought heightened levels of uncertainty. Many of these issues, particularly trade, lack a clear path to resolution, and may yet continue to create instability in markets. There is also the non-negligible matter of a US central bank raising interest rates, lifting borrowing costs globally, and a Chinese economy which could be slowing faster than the market is anticipating.
As we discussed in last quarter’s review, though President Trump’s ideology doesn’t neatly fit with either political party, we do know that he is opposed to Free Trade. Those credentials were emphatically endorsed in June when Trump announced his intentions to levy an additional $200bn of tariffs upon Chinese imports, and to restrict direct Chinese investment into the US economy. China has vowed to retaliate in a targeted and proportionate manner. The ‘targeted’ element is arguably a requirement given Chinese imports of US goods do not total $200bn on annual basis.
Indeed, it is this economic mismatch which has led some to assume Chinese authorities are intervening in currency markets to devalue their currency (yuan), attempting to keep Chinese goods competitive in response to the tariffs imposed. Despite this seemingly logical narrative, we are sceptical this is an accurate explanation. More likely investors have been betting against the currency as economic prospects have dimmed. Certainly, the deteriorating trade outlook does little to help on that front, but industrial production and retail sales also disappointed over the quarter. Measures of annual changes in house prices have also showed modest declines in the major cities.
It is highly unlikely the Chinese leadership would allow their economy to slide into a more worrying phase of decline, as evidenced by their easing in bank lending restrictions in June, however, a direct move on their own currency seems illogical. Not only would this be an extremely antagonistic move toward the White House, but it would disgruntle regional actors as their competitiveness is also undermined. Such a strategy is hardly becoming of the global flagbearer for free trade either, which China is trying to reframe itself as.
The $200bn additional threat comes atop the tariffs on steel and aluminium products that, itself, covers global producers, including those from within the European Union. This position has been met with a firm response with the EU applying a range of tariffs on US imports which includes whiskey, peanut butter and Harley Davidsons. Indeed, Harley Davidson’s announcement that it may choose to shift production to the EU, to evade the dual margin squeeze from increased cost of materials and decreased competitiveness from tariffs, came as some relief to markets. This strategy, from such an iconic US brand, is a sobering reminder to the Trump administration of how difficult Trade Wars are to win.
Italian Radicals meet The Bond Market
The market recovery was also briefly interrupted in May as two of the more extreme, and diametrically opposed, elements of the Italian political spectrum, Five Star Movement (5SM) and Liga, attempted to forge a coalition government. Their first attempts were thwarted however, as the President deemed the appointment of an openly anti-euro Finance Minister to be unconstitutional. This view was taken on the basis electoral campaigning had not promoted such a strategy. Rather than going back to the electorate to seek a more convincing mandate however, 5SM and Liga diluted their proposed cabinet with far more moderate personnel. At a political level this might seem a strange move, particularly as the polling suggested Liga had all the momentum heading into a potential second election. Circumstances were such, however, that capital markets were having their own say. The threat of a more explicitly Eurosceptic leadership was being countered by a surge in borrowing costs for the Italian government. Despite their ideology, it appears Liga were not willing to take on the might of the bond market. It also seems the euro, so often considered the straightjacket for its member states, is at least shielding its member states from the risks associated with more radical policy settings.
Central Bank Safety Net Lowered
There were no surprises from the US central bank in June when, for the third quarter in a row, interest rates were raised by a single notch. What is becoming increasingly clear is that US central bankers are likely to maintain this flight path even in the face of ongoing market anxieties. In the past, with inflation on its knees and unemployment still elevated, the US central bank has been only too willing to respond accommodatively to stock market weakness. With the economy having reached something close to full employment, and with inflation approaching its target, it is unlikely that such an insurance strategy will be so quick. This realisation has manifested in a better quarter for the dollar and a weaker one for Emerging Markets, whose dollar denominated debts become that much more challenging to service.
Progress in Brexit negotiations, both within Parliament and with our EU partners, is evident, if a little glacial in pace. But as much as this story dominates the headlines, it would seem markets remain relatively uninterested. The pound has certainly cheapened up against the dollar, but this is commensurate with the US enjoying better economic data. In Europe, where we have seen relative economic disappointment, we have seen no such weakness. Sadly, however, the UK has also disappointed, particularly in the construction and manufacturing sectors, thwarting the intended March interest rate hike and placing intentions to act in August firmly in jeopardy. As a result, sterling has been broadly flat against the single currency.
Of course, the biggest event over the quarter has been the arrival of the FIFA World Cup, where hosts Russia dismantled their Saudi opponents in the opening fixture. The result seemed to have had no adverse effects on relations between President Putin and Crown Prince Mohammed bin Salman, however, who watched the game in each other’s company. Indeed, just days later they were able to agree on oil production increases to meet the ongoing recovery in global demand and associated rise in price. It is not for certain such a strategy will limit the surge in oil prices however, as Venezuelan production deteriorates faster than anticipated and Trump attempts to render Iranian supply ‘unavailable’ via sanctions. But neither are we calling for a bear market. Quite simply the oil price remains one of the most difficult assets to forecast with so many variables at play.
Reliving the spirit of 1966 has become a popular past time this year and, in a strikingly similar fashion, bold predictions are also starting to hit the headlines…
"A geologist stuck a figurative dipstick into the United States' oil supplies Tuesday and estimated that the country may be dry in 10 years."
August 3, 1966 Brandon Sun (Brandon, Manitoba)
Ben Gutteridge, CFA
Head of Fund Research, Brewin Dolphin
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