23rd November 2020
A fortnightly look at global financial markets by International Investment Strategist Tom Elliot.
Vaccine success drives risk assets higher
The risk posed by Trump and other populists
Bitcoin benefits from professional investor interest
A weak dollar?
A deal is priced into the pound
Market sentiment: ‘Risk on’, but with reservations. Successful final-stage Covid-19 vaccination trials have led to a rally in risk assets, benefiting economically-sensitive cyclical stocks, and stock markets with a large weighting in such companies. The U.K main market, heavily weighted towards energy, financials, and mining, has substantially outperformed the U.S market this month. However, while there is light at the end of the tunnel, the tunnel is of unknown length. It may not be until next summer that sufficient numbers of people are vaccinated to allow a full return to normal life, and even then, ‘normal’ may look different from how it did pre-Covid. There is, therefore, some apprehension that between now and then a run of bad news flow could trigger a return to ‘risk off’ trades.
Investors would be best placed by ensuring that they have a diversified portfolio. Certainly the VIX index of implied volatility on the S&P500 (the so-called ‘fear gauge’) has come down in recent weeks, but at 23 it is still around ten point higher than the long term average of the last decade, suggesting little consensus in the market on the near future for stocks.
Where lie the risks? The key risks are from rising unemployment over the coming months, and of corporate bankruptcies with a possible knock-on effect on banks. Related to this is the worry that central banks and governments reverse their bankrolling of the economy prematurely, perhaps for political reasons. Here the U.S looks vulnerable, as the outgoing Trump administration threatens to demonise those Republicans in Congress who might be prepared to work with Democrats. Trump retains a grip on the Republican Party because of his large support base.(Indeed, The Economist reports that 80% of Trump voters believe his claim that the election was ‘stolen’ from him).
Enter Munchin and Eastern Europe. Ominously, on the 19th November Treasury Secretary Steven Munchin demanded that the Fed ends some of its lending programmes to businesses, which have supported the credit market, because ‘they have clearly achieved their objectives’. This premature evaluation risks politicising a key support for the economy. If the market loses confidence in the independence of the Fed, and in its ability to maintain liquidity in bond markets, these markets risk seizing up with a knock-on hit to stock markets as investors flee risk assets.
Munchin may genuinely believe that the U.S economy is in the clear, although this isn’t reflected in the rapidly rising number of Covid-19 deaths we are seeing in the country. Or he may be positioning the Republicans as the party of orthodox monetary policy, ahead of a period of opposition, and believes that any damage to the economy can be pined to the Democrats.
Meanwhile, Europe’s recovery could also be hurt by anti-democratic governments. E.U’s Euro 750bn recovery programme package of grants and loans to its member states has been blocked by Poland and Hungary, because of provisions that enable distribution of funds to be suspended if countries do not comply with the rule of law. Both countries have seen their judiciaries and their media circumscribed by populist governments.
Bitcoin. The virtual currency has risen 50% in the last month, to $18,219. It is in striking distance of the $19,458 high seen in December 2017. Bitcoin has attracted hedge funds and other professional investors, who are using it to diversify their portfolios and as a hedge against inflation. Bitcoin prices have no correlation with equities (or, indeed, any other financial asset), which helps reduce portfolio volatility.
A weak dollar? Bitcoin supporters will also point to dollar-specific risks as a reason for Bitcoin’s rally. There are two key arguments for thinking that the USD will weaken over the next 12 months, as the American and the global economy recover. The first is the current account deficit. The U.S does not pay its way in the world, running a current account deficit of 2.3% of GDP (amongst the 40 largest economies, only Turkey, Egypt and Saudi Arabia exceed this). As the focus of global economic activity shifts to Asia, the ability of the U.S to continue to attract overseas capital to make up the difference comes into question, and if capital can’t be found the U.S currency may have to adjust.
The second reason to perhaps be sceptical over the dollar is a more cyclical theme. As the global economy recovers, investors will be drawn to riskier assets. This means non-U.S equities and bonds. The effect on currencies is straightforward: the dollar falls as investors sell -for arguments sake- U.S Treasuries, and buy shares in Taiwanese semiconductor chip manufacturers.
Brexit and sterling. The odds favour a U.K / E.U trade deal in place by the end of December deadline, given the aversion of the U.K government to the expected chaos at Britain’s ports on 1st January if no deal is in place. But it will be a hard Brexit: tariff and quota-free, but customs forms and border checks to ensure that the U.K is complying with ‘rules of origin’ legislation that prevents goods from other countries entering the E.U. As discussed in previous editions of this note, the sticking points are fish, ‘level playing field’ conditions (such as environment and state subsidies), and the role of the ECJ in policing any agreement.
Currency analysts believe a deal will lead to only a modest rally for sterling, since it is considered the most likely option. A no deal would, therefore, lead to a lurch downwards for the pound.