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Monthly Market Commentary - September 2019

Market performance for August

Markets have been dominated by trade tensions between the US and China, weakening global growth and expectations of interest rate cuts. Investor demand for safe haven assets resulted in a further fall in bond yields, with long-term US bond yields dipping below short-term yields. Ten-year bond yields dropped to 2019 lows in August: 1.5% in the US, 0.48% in the UK and -0.7% in Germany, where all government debt now trades with a negative yield. In the UK, inflation worries pushed up breakeven rates with index-linked gilts returning 4% over the month.

Stock market volatility increased on the prospect of declining corporate earnings as well as trade uncertainty, with the major indices losing between 1% and 5%. The FTSE 100 fell 380 to 7,207 reflecting the weighting to resource stocks like miners, rather than specific Brexit concerns. Currency markets were also volatile, although sterling ended little changed on the month at $1.22. Gold rose 7% to $1,522 on falling real interest rates and increasing geopolitical risks while Brent crude was down 6% to $60 on growth fears.

Trade policy remains centre stage

Recent tweets suggest the long-running tariff war will continue even though a ‘great deal’ is needed at some point to boost the President’s re-election hopes. Tariffs can be increased to 50% if China discriminates against US commerce and trade could be blocked completely if a national emergency were declared. More extreme retaliatory measures could extend to restrictions on the purchase of US assets, access to financial markets or de-listing Chinese companies. Given China’s unpopularity in the US and bipartisan consensus on intellectual property theft, it appears increasingly likely  that a deal will be prompted by economic pressures.

As global growth continues to slow, protracted trade tensions could lead to recession. In advanced economies, there continues to be a divergence between domestic resilience (services and the consumer) and external contraction (global trade and manufacturing).

Trade volumes are the lowest since 2012. Capital goods imports – a proxy for companies investing or upgrading their physical assets – are contracting year-on-year. Business surveys point to widespread weakness. While this may be partly attributable to distortions caused by pre-tariff stockpiling, we should be reaching the point where these distortions unwind and a clearer picture emerges of the post-tariff environment. However, some forward-looking cyclical indicators – such as ISM New Orders – imply further weakness ahead. A combination of jobs growth, wage increases and tight labour markets has supported real disposable income and consumer confidence but the likelihood of recession in 2020 increases if trade weakness persists and companies start cutting back.

In the developing world, Chinese GDP has slowed as expected but the policy response is still surprisingly measured and appears to prioritise the exchange rate over other metrics. While credit has been restrained by historic standards, policy is supportive and the fall in short rates has provided some relief for the renminbi.

Further easing expected from central banks

An increasing number of central banks are attempting to prolong the economic cycle. The challenge is that with most nominal rates at zero, negative real interest rates and supportive financial conditions, monetary policy is losing its effectiveness. Despite consumer resilience, the Federal Reserve is expected to cut rates by a further 0.25% this month and bond markets are discounting a 1% cut in interest rates over the next year. The European Central Bank is likely to announce a new quantitative easing package including another rate cut, further asset purchases and updated forward guidance. The exception is Japan where policy is already very accommodative.

Boris, Brexit and portfolio positioning

With the UK heading for a ‘no deal’ Brexit on 31 October, attention has focused on the potential economic impact. The absence of pre-agreed transition arrangements means the EU and UK would no longer recognise cross-border business licences requiring the introduction of new customs and regulatory borders overnight.

The assumption is that trade with the EU would default to World Trade Organisation rules and tariffs although the EU is rumoured to have drafted emergency arrangements. While this could limit the immediate economic impact, adapting to new paperwork – for trading with the EU and the rest of the world – will incur significant costs. The impact on each sector would vary even though in many cases tariffs are not high (2.8% on average for manufactured goods) but 10% on cars and 9% on agricultural goods would be more problematic. Depending on the level of EU protectionism, trade could cease in highly regulated sectors like financial services, pharmaceuticals and chemicals.

Given that the EU accounts for around 40% of UK exports of goods and services, the cost of Brexit disruption is expected to be meaningful over the next few years. The estimates we have seen – based on standard WTO tariffs, an allowance for disruption costs, a limited (say 5%+) decline in exports, lower investment and stable consumption – suggest UK GDP could be 2%-3% lower over the next two years than would otherwise have been the case – i.e. flat from this point.

The government is, of course, likely to ease the pain by keeping tariffs very low on essential imports and cutting taxes to fund spending. This fiscal stimulus could well exceed the £27bn ‘Brexit Reserve’, which the previous Chancellor had set aside, and be worth 2% of GDP or roughly half the 2009 financial crisis package. It is much harder to judge the longer-term impact as this will depend on the terms of new trade agreements with the EU and other areas.

Against this backdrop, positioning portfolios for Brexit has not been easy, especially given the growing Parliamentary opposition to the Prime Minister’s ‘no deal’ departure and the likelihood of an autumn election. Another complicating factor is that the UK has a very ‘open’ economy – more so than the US – with a high proportion of GDP dependent on global trade.

For risk assets such as equities, this has shaped our preference for multinationals that should be more robust in a ‘no deal’ scenario. Our broad sector exposure avoids companies we see as facing structural challenges and is focused on those generating strong free cash flow. It includes well-established household names as well as new growth opportunities.

Fixed interest is particularly challenging because UK government bonds tend to move with global markets, rather than just react to Brexit news. There is also the risk that UK yields rise unexpectedly if the debt position deteriorates materially. Index-linked gilts provide protection against extreme inflation while gold offers insurance against geopolitical risk. Sterling is probably the greatest challenge in part because it is a liquid market. Our positioning is already biased away from sterling but we are conscious that speculators have pushed the currency towards the lower end of its valuation range and a ‘less bad’ Brexit outcome could see a reversal as positions are closed out.

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