Current racing conditions: remaining soft. Q3 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income relative to benchmark. Prefer emerging stock markets to developed, positive on gold. Longer term outlook is to be pro-risk assets.
This week: Is soft Brexit achievable? Yes, but the politics are against it. What if market consensus is wrong the impact of a Clinton/ Trump victory on capital markets?
Markets remain nervous, with investors in all assets nervous that central bank’s loose monetary policies of the last eight years appear not to be working and unsure if the central bankers have a Plan B. I suspect that we are more likely to see a Plan B emerge from governments, in the form of looser fiscal spending over the coming years.
Last week the Fed and the Bank of Japan made easily-forgettable announcements. The Fed announced no change to interest rates, appearing nervous that a premature rate hike may trigger an economic downturn, U.S and global stocks rallied in relief. The Bank of Japan announced relatively minor tweaks to their existing QE program, the most important one being to aim to cap the 10 year JGB yield at zero percent. Following on from the ECB’s September meeting, in which it declined to enlarge its QE program despite continuing weak economic data, investors are left with a growing suspicion that the BoJ, the Bank of England and the ECB have all run out of new tricks to stimulate growth and inflation. Meanwhile, persistently ambiguous U.S economic data deters the Fed from its goal of normalising interest rates to the 3-3.5%level.
But there is reason to believe that looser fiscal policy might be around the corner: in the U.S, if Donald Trump wins the presidential election (see below), in the U.K the new government appears keen to renounces the austerity policies of its predecessor, in the euro zone now that the German finance ministry has achieved its goal of eliminating its budget deficit, and in Japan where a large fiscal stimulus package is expected to boost consumer demand.
Such a Plan B will not be an officially announced and co-ordinated policy by governments. It will be piecemeal, and greeted with alarm by government bond investors as they realise the scale of fiscal stimulus to come. But the inexcusable demand of central banks for bonds, together with demographics and a rise in the number of people requiring a secure income stream in their old age, may limit the rise in bond yields. Stock markets will not find a rise in bond yields comfortable, with bond proxy stocks underperforming. But financials will benefit from steeper yield curves, and growth sectors and consumer stocks will be able to raise prices in line with inflation from an increase in demand as unemployment falls and real wages rise.
Is soft Brexit achievable? Yes, but the politics are against it.
Philip Hammond, the U.K Treasury minister, wants the U.K to retain strong trading links with the E.U. For him, retaining access to the single market for goods, services, capital and people, and remaining in the E.U’s free trade (ie, no tariff) zone, are all-important to ensure continuity for the economy after Brexit. In particular, he is under pressure to secure continued passporting rights for U.K financial institutions. To secure this would almost certainly mean continuing to pay into the E.U budget, and continuing to comply with single market rules that the U.K would now have no say in making. The U.K may get a minor deal on the movement of people, perhaps allowing immigrants from the E.U to be only allowed to work in the U.K if they have a pre-arranged job to go to when they arrive. This arrangement has been dubbed ‘soft’, or ‘light’ Brexit and it exists in a slightly similar form for Norway, and so should be achievable.
Since 48% of the electorate voted in the referendum to remain in the E.U, and the 52% who voted to leave were deeply divided as to what Brexit should mean, a majority of all voters may be willing to live with this. As could Parliament, where a majority of MPs are thought to have been sympathetic to the Remain camp during the referendum. The campaigner-in-chief for the Leave campaign, foreign minister Boris Johnson, himself suggested that Britain could somehow achieve Brexit while remaining in the single market.
Since the referendum it has appeared that Prime Minister Theresa May might also be aiming for such an outcome; she has thrown out a key demand of the Brexit supporters for an Australian-style points system for immigration, and has criticised her Minister for Brexit, David Davies, for claiming that leaving the E.U will mean exiting the single market.
However, such a deal would evidently not be what a portion of Brexit voters thought they were voting for. For these people a Norway-like deal would be a deceit. It would be red meat to UKIP, a political party in need of a goal since it achieved its aim of winning the referendum. And it would result in immense pressure on Conservative M.Ps from indignant party members (who tend to favour a full break with the E.U more than their M.Ps do).
So just as we got a referendum on the E.U to pacify a part of the Conservative Party that wanted to leave it, so we may get a ‘hard’ Brexit to pacify the same group. A referendum on any final Brexit agreement made with the E.U, or a general election in which the country can decide via Parliament, is surely called for.
What if market consensus is wrong the impact of a Clinton/ Trump victory on capital markets?
The consensus is that a win for Hilary Clinton in November’s Presidential vote will be welcomed by financial markets. Investors like continuity and predictability in politics, which she offers. Donald Trump offers neither. An interesting anecdote from U.S financial history is that the U.S stock market has traditionally performed better under Democrat presidents. But this scenario is based assumptions that may be confounded by the candidates themselves. Let’s consider different possible scenarios.
A Clinton victory accelerates a decline in global trade. Upon a Clinton victory, investors relax. The Fed continues to try to raise interest rates, perhaps starting in December, with two further hikes next year. Although stock market investors will be concerned that the resulting rise in Treasury yields will put the S&P 500 under threat, this fear will be countered by an assumed continuity of economic policy from the White House.
However, Hilary Clinton has been forced to take an anti-globalisation stance in order to win the Democrat nomination from Bernie Sanders, and she has renounced some of the trade deals that she helped create. Global trade -as a percentage of world GDP- has been falling in recent years, probably resulting in slower global economic growth than would otherwise have been the case. Without the impetus that comes from new trade deals, there is a real risk that anti-globalisation forces gain the upper hand in the U.S and other industrialised countries. Trading partners impose tit-for-tat tariff and non-tariff barriers. This persuades the Fed to put further interest rates on hold in 2017 in order to prevent recession, as exports collapse, despite a fall in the dollar. Gold rallies as international political tension mounts, triggered by trade problems.
The above would probably a good environment for Treasuries, with the asset class also benefiting investors from its status as a safe-haven asset. Bad for U.S and global stock markets. This is a scenario more often associated with Trump.
A Trump victory boosts the U.S economy through fiscal expansion. Consensus is that the Fed is more likely to avoid a December interest rate hike in the event of a Trump victory, than a Clinton victory, as it tries to steady investors’ nerves, and that Trump victory will be a disaster for investors. But if a continuation of the Fed’s dovish stance into 2017 will boost equities, and Donald Trump manages to assemble a team of sober advisors, a recovery in the U.S economy to normal growth levels may be possible.
Many Republicans believe that Trump can be ‘captured’ by the mainstream Republican party once elected, since he will be dependent on Republicans in Congress to get legislation passed (Presidential decrees can only do so much). In this view, Trump announces a modest package of measures against Chinese imports, which Beijing accepts as a token gesture to satisfy the Trump support base, and does not retaliate with its own trade measures. Business persuades Trump not to over-do his anti-immigration stance. Trump oversees a fiscal expansion, led by an increase in defence spending and cuts in corporate and perhaps personal taxes. This increases demand in the economy, at a time when the labour market is already tight, should then lead to an acceleration in wage growth and inflation. At last the hawks in the Fed can then persuade their colleagues of the need to raise interest rates against a back ground of stronger economic growth, and indeed interest rates are ‘normalised’ over the next few years.
Stock market rally, driven by rising profits, although bond proxy stocks underperform the market as the risk-free rate rises. However, Treasuries fall into a bear market. The dollar rises, gold falls in price.