It is fair to say that it has been a strange summer. Greek government bond yields have traded below those of the US. Sterling has strengthened on the hopes of a Corbyn government. President Trump labels his own central banker as an enemy. The Brexit negotiations have transcended farce - as they say, even Baldrick had a plan. The British government would collapse if only the opposition would allow it. China has been labelled a currency manipulator by the US on concerns that a weak yuan gives it a trade advantage, yet the PBoC has been intervening to support its currency! If you are finding all this a bit baffling, join the club.
Economic conditions have been steadily deteriorating throughout the year and global manufacturers clearly face difficulties. Forecasts of 2019 global GDP growth have been pared back from 3.6% at beginning of the year to 3.2%. The trade war is a cause of the slowdown, although not the only one. The malaise seems to be deeper than this and may be centred on Chinese attempts to regain control of their money supply as they clamp down on their shadow banking system. Rumours of a cash shortage are emerging. Note that Chinese growth is not dependent on exports, over 70% of GDP growth alone comes from domestic consumption. US exports constitute only 4% of the economy. Tariffs are unhelpful for the Chinese, but are not the root cause of the slowdown.
China shows few signs of making significant trade concessions and Trump looks like a bluffer facing someone who holds all the aces as he ratchets up the tariff ante. Most recently he has offered to delay the next cycle of tariffs, as he follows his now familiar trait of blowing hot and cold. He appears to be painting himself into a corner as the election looms and I am sure the Chinese know it. We expect no swift resolution to the trade war, unless Trump can find some face-saving solution. If a recession does develop in the US over the coming quarters, it will dash Trump's hopes of re-election. A Democratic President might look to undo Trump's tax cuts which would have implications for the stockmarket.
Trump's erratic behaviour must be maddening for businesses. Manufacturers can reroute their supply chains around China but this comes with disruptive costs. The question is where do you go? Tariffs are a weapon that Trump can wield without Congressional approval. Like any bully, Trump seems eager to threaten with his stick. Businesses relocating supply to places such as Vietnam could end up being embroiled once again if the trade war extends. Worryingly, Trump has shown signs of being prepared to use it for political purposes as well such as to combat immigration. Where else will he apply it? Many modern industrial supply chains operate on a just in time basis. Inventories and costs will climb if the uncertainties persist.
Overnight, the Fed cut rates by a quarter point although the FOMC decision was not unanimous. The market had largely discounted a cut though there is now an expectations gulf between the market and the Fed dot plots, the latter suggesting little move from here. The market is not always right but more recently, short term bond prices have been a more reliable indicator than the FOMC. Trump throwing brickbats at his central banker is unhelpful and possibly counterproductive, but he may be right in calling for lower rates. The budgetary imbalance is a concern to us, but the market seems remarkably unconcerned by this. Perhaps we should look to what has happened in Japan.
Recessionary indicators are beginning to flash. The Treasury bond yield curve inversion has been followed by the US PMI dipping below 50. Global freight indices are slowing though probably reflecting what is happening with global trade. Indicators from the US housing are more mixed depending which ones you concentrate on, though Robert Shiller detects signs that the market is rolling over. The consumer remains optimistic and the jobs market strong but there are some early signs of potential trouble here if you look hard enough. We are also conscious of the waning effects of last year's tax cut package. By the end of 2019, the impact of the base effects dropping out will turn negative for overall GDP.
The odds of a hard Brexit on 31st October have risen, though the chances of any resolution by then are modest despite Johnson's words. Our portfolios are underweight sterling and we question whether this is wise. On consideration, we believe it is. A hard Brexit will be damaging for the long term prospects for UK growth and by extension our clients. Underweight sterling helps to offset that risk. We face relative risks in the event of a positive resolution, the most positive scenario for markets would be an abandonment of Brexit. However, the chances of this happening by 31st October are as likely as someone going to their local barber and asking for the 'Boris look'.
We see reports of increasing pressure on UK commercial property. We know that the retail sector faces a daunting structural issue. Office space now seems to be struggling as Brexit and other factors begin to increasingly bite. It takes time to bring supply out of these markets so price moves could be sharp. This is no time to be locked into a potentially illiquid asset and we are very happy to have no exposure to direct property.
We also retested our conviction in our overweights in Japan and GEM. Both markets are exposed to global trade flows and can be volatile. However, they are cheap and the former benefits from the perceived defensiveness of the yen. On balance we agreed to stick with both.
We discussed reducing equity in the face of the growing recessionary risk. On balance we reason that to be a mistake. We are far from sure that a recession will occur and doubtful of a serious one developing. Equities will be knocked if one hits but a true bear market appears unlikely. The collapse in bond yields has left chunky equity risk premiums. For example, 30 year bunds on -0.2% yield look a poor alternative to European equities yielding 3.8%. Instead we shall take action to increase duration in our fixed income holdings and switch into lower beta, interest rate sensitive equities.
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