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Q2 2019 commentary

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After a blistering start to the year for stock markets globally, the second quarter saw a modest loss of momentum. Yet, whilst directional trends remained positive, the accompanying levels of volatility moved higher. The most coherent explanation behind this more frenetic journey for share prices, has been the deteriorating trade negotiations between the US and China. The most likely reason as to why these actions haven’t inflicted more damage upon the global financial system, has been the firm shift to a more accommodating policy setting by the world’s major central banks. Towards the end of June optimism also increased that the US and China trade talks might resume.

An approximate return of 3% from the UK stock market over the period is an impressive showing, but with gains of more than 6% enjoyed by overseas equities, it is clear political risks are continuing to weigh on domestic sentiment.

Trump ‘n’ Tweets can be Stock Market TNT

On May 5th US President Donald Trump tweeted the US would raise existing tariffs from 10% to 25% on $200bn of Chinese imports. In the same tweet, Trump also revealed he would be looking to initiate tariffs on an additional $325bn of Chinese imports. Soon after, the first of these commitments were fulfilled and, soon after that, the Chinese had responded in kind. In the midst of these more fractious trade developments, stock markets faltered.

When the two largest economies in the world are engulfed in a bilateral trade conflict it would be natural to assume the global economy could move into rapid decline. Whilst not ruling this out as a potential, it is worth contextualising the scale of the problem. According to the United States Census Bureau, in 2018, at approximately 15% of GDP, imports represent a relatively modest proportion of US GDP. From the same source we also learn that just 16% of these imports come from China. Recalling that not all Chinese imports are covered by the new tariff regime, we can begin to draw some comfort from the relative insignificance of the spat upon the US economy. Turning the tables to examine the challenge from a Chinese perspective, and the importance grows, but at roughly 3.5% of GDP the scale is still not significant.

With global supply chains a complex interwoven mesh, it would be inappropriate to say these numbers tell the whole story of US-China trade. We should, however, feel confident enough to determine the current US-China disagreement only scratches the surface of global trade and, whilst not helpful, is not enough (on its own) to topple the global economy.

What is perhaps of greater concern to markets, therefore, is the fear this conflict may escalate and spread. One example of how this might happen can be seen in the case of Chinese Telecom giant, Huawei. With the Trump administration placing Huawei onto a restricted list, and effectively stopping US businesses from engaging without government approval, there is an implicit call for partnering nations of the US to follow suit; or potentially face retaliatory action.

Other examples of Trump’s ambitious trade policy, threatening a more global imbroglio, include talks with Japan, the EU and a resurgent assault on Mexico. This growing collection of disputes has added to market anxiety over the past year given the uncertain outcome in each instance. This uncertainty does not predetermine failure, however. Indeed, at the G20 meeting in Japan in the final days of June, Trump revealed China talks were “back on track”, citing the Chinese gesture to buy more US farm products as the major catalyst for the détente. The proposed 25% tariff on the additional $325bn of Chinese imports were put on hold, and restrictions on Huawei were eased.

Despite the positive tone to Trump’s analysis of his talks with Chinese leader, Xi Jingping, Trump also reminded us the two countries remain at odds over significant elements of any potential agreement. Such challenges make it hard to conclude a deal will soon struck and, therefore, shouldn’t be considered as the dominant force behind the June surge in global stocks.

Data and Policy

With the geopolitical climate remaining a worry, it would surely be of great comfort to investors to see the economic data improve. So far, however, such an outcome has failed to materialise. Whilst there is little evidence to suggest we are in a recession, there is plenty pointing to a slowdown in global growth. Souring surveys of performance from within the manufacturing sector would be one such example, as well falling levels of inflation; pointing to a lack of pricing power and diminishing business and consumer confidence.

It is the combination of deteriorating prospects for geopolitics, growth and inflation, however, that has afforded global central banks, particularly the US Federal Reserve, the flexibility to become so accommodating. In the case of the US, when growth and inflation were accelerating moving into 2018, the Federal Reserve were signalling up to four interest rate hikes for 2019. Fast-forward to today, however, and it would now be a huge shock to markets to see even a single hike this year. Indeed, recent communications suggests an interest rate cut in July is a near certainty, with perhaps more to come.

The importance of the Federal Reserve guidance for its policy should never be underestimated and the U-turn on interest rate hikes has likely been the key pillar of support for the more recent move higher in stocks. The main reason for this relationship is that it is hoped a more cautious interest rate setting can extend this long economic cycle yet further, delaying the onset of the next recession; an outcome widely accepted as a difficult environment for profit generation and share price appreciation.

Worldly Goods

As previously mentioned, the move to a more generous policy setting has been seen around the globe, not just in the US. In China, following a period of economic and environmental reform, a period of greater economic pain than intended, has been the result. To alleviate some of this strain, the more recent policy response appears to be a reversion to policies of old i.e. fiscal stimulus such as tax cuts and greater state spending. The US-China trade conflict has also added to China’s need to move in a more growth friendly manner. Indeed, notwithstanding the likelihood for increased market volatility, it could be that China’s corrective stimulus fully offsets any drag on growth from a suboptimal US trade outcome.

The European Central Bank has also had a busy quarter, revealing its willingness and flexibility to support growth, even before the Federal Reserve. Also reigniting prior policies, in September this year the ECB will reinstate cheap lending facilities to European Commercial Banks, on the basis this new money finds its way into the wider economy.

A New PM but Old Challenges

Continuing to dominate domestic news wires has been the repeated failure of Parliament to arrive at an agreement over how to deliver Brexit. This stalemate has cost the Prime Minister her job and the Conservative party are in the process of electing a replacement. No matter the intentions, ideology or charm of the two remaining candidates, the new Premier’s strategy will attempt to amend the backstop within the existing arrangement or else force a ‘No deal’ separation.

 

 

“Plus ça change, plus c'est la même chose” (the more it changes the more it stays the same)

Jean-Baptiste Alphonse Karr


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