Investors’ attention has been dominated by political risk recently. This is no surprise given the pending US elections, European political risk and the impact of Brexit on the UK economy. The article highlights what 7IM is doing in this scenario.
Investors’ attention has been dominated by political risk recently. This is no surprise: while current polling suggests that a Trump win looks unlikely without a major new scandal erupting around Clinton, markets are understandably reluctant to say it’s impossible until the polls are closed and votes are counted. So, in the meantime, markets have to price in at least the possibility of a sharp turn against globalisation and international co-operation by the US under a Trump presidency. Closer to home, European political risk is a little lower down the agenda, but the Italian constitutional referendum in December may present a banana skin. Then add in elections in France, Germany and the Netherlands in 2017 against a climate of populism, anti-immigration and anti-globalisation rhetoric, all of which are starting to weigh on investors’ minds.
Of course, huge uncertainty still hangs over the outlook for the UK and its future relationship with Europe: an inflexible stance by the UK government on controlling European Union (EU) migration is colliding head-on with an uncompromising position by the EU on its four basic freedoms. These tie membership of the single market to the freedom of movement of goods, capital, services and people. Unless either party can give ground, and it is hard to see politically how they can, this suggests that a favourable trade deal for the UK will be hard to negotiate. It’s dawned on markets that Brexit probably means a hard Brexit, with negative implications for trade, investment and productivity for the UK economy, and with the Pound as the key battleground.
We shouldn’t expect hard economic data to show much impact yet, but we’ll start to see more effects in the months to come – not only through imported inflation, where high profile stories are already grabbing attention, but also in cancelled or deferred capital investment decisions. This may not come to a single dramatic defining moment, but suggests a drip-feed of disappointment, where economists are gradually reducing their long term expected growth trajectory for the UK, and where the government has to respond to a lower expected tax base as a result.Animal spirits are not strong enough to fuel a significant acceleration in growth and corporates are generally still very cautious about investment plans.
Elsewhere, we see little to challenge our expectations of a subdued but steady growth outlook. European economic data has surprised a little to the upside recently, offsetting slightly underwhelming US data, but the broad pattern holds good: labour markets in the US and Europe are strong enough to support the consumer, the key driver of these economies. And China’s policy interventions have again stabilised growth drivers there enough to prevent a hard landing. However animal spirits are not strong enough to fuel a significant acceleration in growth, corporates are generally still very cautious about investment plans and, while governments have generally pulled back from recent austerity drives, few have either the will or the fiscal wriggle-room for major stimulus. While infrastructure spending plans may bear fruit in the long run, time taken to plan new projects and overcome local objections suggests we shouldn’t hope for much real world impact in the near term.
While there may seem to be a narrower range of likely outcomes for the global economy – fading a bit, brightening a little, but neither racing to escape velocity nor falling off a cliff – the range of possible actions by policymakers seems wider and has profound implications for markets. Markets seem, for now, to be taking in their stride the possibility of another rate hike by the US Federal Reserve in December, assuming there is no meaningful weakening of the economic data before then. Indeed, there are some who would strongly welcome it, both as a signal that the US economy is a step further on the road back to normality, and as a move to rebuild policy flexibility for the next downturn, hiking rates now so that they can be cut later. But perceptions can change, and it would not take much for a hike to be perceived as a policy misstep, tightening policy for an economy that needs ongoing support.
The policy debate in Europe and Japan is a little different. With interest rates below zero and asset purchases – Quantitative Easing (QE) – continuing to expand central bank balance sheets, the tone has shifted. Is QE now the problem, with low bond yields crushing banks’ profitability, undermining corporate pension schemes and forcing households to save ever more to meet their long term goals? Or is it the solution, on a still grander scale, covering more assets and culminating in the central bank cancelling government debt? Is it even necessary, in Europe at least, given that GDP growth of the 1.5-2% we are now seeing is probably as good as it gets for a demographically-challenged continent? And, if it’s not the solution, what is? Central bankers’ statements and investors’ interpretations of those statements look likely to be a bigger factor than economic surprises in driving markets.
Yet, despite elevated political risks and uncertainty around monetary policy, stockmarkets have traded up to their highs for this cycle, with valuations looking increasingly demanding. Not high enough to preclude further progress – momentum and sentiment can be powerful forces – but high enough to already factor in the fairly decent earnings growth. We should indeed expect reasonable earnings growth for 2017, as headwinds from the energy sector’s pain fade away. But it’s hard to see where substantial positive surprises can come from. This pushes our focus more towards riskier corporate debt – pricing is still reasonable and the economic outlook is resilient enough to suggest that corporate defaults should be lower than priced in by current credit spreads. And, if we are wrong, debt should significantly outperform equity in a downside scenario.
Deputy Chief Investment Officer
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