19h October 2020
A fortnightly look at global financial markets by International Investment Strategist Tom Elliot.
A ‘blue wave’ supports U.S stocks
But new waves of Covid-19 cast a shadow
Goodbye austerity, hello big deficits
U.K/ E.U trade deal: will Boris really risk a no-deal?
An ‘Australian-type deal’?
Market sentiment: Some optimism on global stock markets, cautioned by fresh waves of Covid-19 and re-introduction of social distancing measurers. Expectations are growing amongst investors of a Democrat clean sweep at November’s U.S elections, which may trigger a large new fiscal stimulus package, giving support to the economic recovery. The IMF has issued an improved global economic outlook, thanks to the remarkable recovery seen in China and stronger than expected data from much of the developed world. It now expects the global economy to shrink by 4.4% this year, a 0.8% improvement on its June forecast. But the recovery in Europe is hampered by renewed lockdowns, and globally people-facing services sectors struggle to recover former levels of demand.
We are seeing on-going support from central banks; for example the Bank of England appears to paving the way for negative interest rates and the ECB is expected to announce more easing of policy in December. Perhaps not surprisingly, defensive assets such as Treasuries have sold off, in what has been described as a ‘modest bear market’ for bonds.
Emerging stock markets and U.S smaller companies have outperformed: this current rally is not just about tech and healthcare. Continental European stock market are lagging those of the U.S and China, but benefit from a strong weighting in economically-sensitive industrials, and consumer goods. The U.K and Japanese blue chip stocks appear relatively unloved and volatile at present, partly for domestic political reasons.
Market volatility is likely to remain high as we approach the U.S election, the U.K/ E.U trade talks drag on, and fresh waves of Covid-19 threaten to undermine the global economic recovery.
Investors should remain diversified. As was said in the previous issue, in the face of uncertainty and market volatility, long-term investors should maintain a diversified portfolio of stocks, bonds and other assets in order to limit risk.
The ‘blue wave’. If Joe Biden wins the presidency on 3rd November, and the Democrat party takes the Senate as well as the House of Representatives, the scene is set for a large fiscal stimulus program early next year. The $3.2 trillion program that the Democrat-controlled House voted through in June may be enlarged, to include New Deal-type infrastructure projects, with a focus on transport and clean energy. Republicans fret that much of the stimulus package will go to Democrat supporters, such as higher teachers’ salaries, rather than invested. The classic Keynesian response is that the multiplier effect on the broader economy of higher public sector salaries is likely to pay for the salary rise, many times over, and will compliment the Fed’s loose monetary policy.
However, the Democrats will not have complete control of all federal legislative bodies: the Supreme Court is, by western standards, oddly political for a country’s most senior judiciary body. It may become more conservative if Trump’s nomination of Amy Coney Barrett succeeds.
The U.S economy continues to show resilience, despite the ending of supplementary unemployment pay in August and rising unemployment (to 7.9%, compared to 4.5% in the U.K). The rapid build-up of household savings earlier this year, thanks in part to the first stimulus package in April, is now being unwound in the form of retail spending. Last week September’s retail sales were reported up 1.9% month-on-month, growing at the fastest pace in three months. It is not just savings fuelling this growth, but also spending previously directed towards travel, entertainment and other parts of the services economy that is now being spent on hard goods.
By stock market sector, U.S energy and financials look vulnerable to a ‘blue wave’ victory at the U.S elections, that lead to a reversal of Trump’s de-regulation on the sectors. The pharmaceutical sector will be under pressure to reduce drug prices, and the large tech companies may face investigations and fines into monopoly practices, privacy issues and fake news. Industrials and green energy look set to be winners. More generally, Trump’s corporate tax cuts are likely to be partially reversed, reducing corporate earnings.
But the picture is nuanced for investors. A more stable policy agenda from the White House will help American companies plan investment, which has been problematic in recent years (especially for any tech company doing business with China). It is expected that the sound volume will be turned down on disagreements with China on trade, tech and security issues, removing a major source of volatility on global stock markets in recent years. In its place will come a multilateral approach towards China, working with Japan and the E.U, which may be more effective in achieving western policy goals, with less noise.
As the chart below shows, is no clear correlation between U.S stock market returns and Democrat or Republican control of government:
Source: JP Morgan Asset Management, Guide to the Markets September 30th 2020.
Goodbye austerity! Last week the IMF officially endorsed government policies of borrowing as much as the bond markets will stand. There will be no need for austerity to follow a few years of jumbo budget deficits. Based on their forecasts for growth and interest rates, by 2025 deficits in most advanced economies will be back to levels forecast before the pandemic. This gives a green light to politicians to spend / invest their way out of recession, rather than tighten their belts, as they were urged to do by the IMF a decade ago.
This about-turn in IMF policies, away from an instance on balanced budgets, reflects three things. First, that in the IMF’s view deflationary forces are so great that a lot more money can be created (through deficits) before economies over heat. And as a result of these deflationary forces, borrowing costs will remain low. Second, the austerity of the last decade helped to create a wave of anti-globalisation political populism that -in its eyes- is potentially more economically damaging than large deficits. Third, institutions are not immune to fundamental changes in thinking. The number of economists who openly advocate 1980s-style monetarism and balanced government budgets is shrinking. After all, Japan has been running large deficits for years, paid for by central banks, and inflation is running at 0.2%.
U.K/ E.U trade deal. U.K Prime Minister Boris Johnson last week walked away from talks with the E.U, demanding a ‘fundamental change of approach’ from Brussels. Since a no-deal will hurt the U.K economy much more than the E.U, it is unclear how much leverage he has if he wants a deal. Michael Gove, a senior minister and Brexit supporter, has recently admitted that leaving the E.U without a deal will have ‘a significant and damaging effect on farmers’, and it is known that there is intense pressure from the U.K business, farming and fishing sectors to avoid a no deal.
It seems likely that Johnson will eventually make significant concessions (eg, the Irish border will be back in the Irish sea, as originally agreed to in the Withdrawal Agreement, but inoperable under the U.K governments new state aid rules). There is little appetite within government to take on the economic and logistical challenges of a no-deal, while dealing with a second wave of Covid-19, although Conservative Party MPs are more supportive of walking away and so ensuring a ‘clear break’.
But Johnson first needs the fig leaf of a concession from Brussels. France’s intransigent position on fish looks indefensible to most observers, given that it refuses to even acknowledge that the U.K has left the E.U. A cave in on this, by France, would give Johnson political cover at home for much larger concessions.
A deal will open the door to the U.K making other trade deals with countries, and hopefully trigger a wave of investment as a large amount of uncertainty is removed. Sterling may rally. But a no-deal will see sterling fall and a downgrading of U.K economic growth prospects, perhaps in line with the government’s own forecasts. These suggest that the U.K economy could be around 5% to 7% smaller in 15 year than it would be if a no-tariff and no-quota comprehensive trade deal is arranged.
Australian-type deal. A word on what Johnson calls an ‘Australian-type deal’. To anyone else, this is a no-deal, even if it sound more acceptable the word Australia in front of it. Australia has no comprehensive trade deal with the E.U, and relies on the same WTO terms as the U.K will, if it fails to secure a deal with Brussels. What Australia does have is a clutch of hard-won and industry-specific agreements, such as for wine, but which the U.K is currently not asking for.