Author: admin@hottinger.co.uk

By Hottinger Investment Management

“In this world, nothing can be said to be certain, except death and taxes”

What US founding father Benjamin Franklin didn’t say (but perhaps knew) was that death and tax policy are deeply interlinked.

That’s the thesis from Kenneth Scheve and David Stasavage, who have studied the history of taxation in Europe and the United States, in their book Taxing the Rich – A History of Fiscal Fairness in the United States and Europe. They find that what we think drives high taxes on the rich – inequality, envy and the ability to pay – doesn’t really show up in the data. It wasn’t universal suffrage or the politics of left- and right-wing governments that drove large increases in claims on the rich in the 20th century, but the need for equal sacrifice in a time of war.

In the 19th century, John Stuart Mill wrote that taxes should be levied to ensure “equality of sacrifice”, but that left open the question of what form these taxes should take: should they be proportional or progressive? This is an unresolved moral issue at least half a millennium old. The introduction of the decima scalata, a progressive tax on land income, in Florence in the year 1500 created a vigorous debate that Francesco Guicciardini – statesman and friend of Machiavelli – summarised in a brief text. There one can find statements that match the sentiment we find across the political spectrum today. Depending on political persuasion, the ideal principle ranges from one that emphasises the ability to pay (progressive taxation, with richer folk paying more as a share of their resources) to one extolling the virtues of equal treatment (proportional taxation, with everyone paying the same share of resources in taxes), or one where everyone pays the same flat fee (regressive taxation).

But there is another way of looking at “equality of sacrifice” that has entertained recent studies in tax history, not least Thomas Piketty’s seminal work on inequality and capitalism in 2014. Following Piketty, Scheve and Stasavage conclude that the effect of two all-consuming and devastating world wars explains the very large increases in taxes on the rich in the 20th century, with those taxes gradually falling back in the following decades. The 1918 Labour Party manifesto called for a ‘Conscription of Wealth’ from the older members of the British population who made money from the war but were not enlisted to fight in the trenches. Equality of sacrifice here meant short-term confiscations from the wealthy in the form of income and wealth taxes, as well as levies on capital and excess profits, to finance the costs of the war and social reconstruction in the years that followed.

Scheve and Stasavage’s major insight is that the countries that mobilised for war – such as the UK, US and France – raised top income taxes on the rich by much more than those that didn’t. While rates were below 10% before the First World War in most industrial countries, they rose to an average of 40% by 1919 in the belligerent industrial states, compared to just 15% in those that stayed out of the war. In the UK, top taxes on income rose to 98% and on large estates to 80% in the period after WW2 in order to fund a growing welfare state that was seen as a reward for the sacrifice of those who went to fight.

As the impact of the wars subsided, so did the demands on the rich – yet the demand for public services has continued to grow. Average top rates of income tax fell from 65% in 1945 to below 40% in 2010 at the same time as the size of government doubled from 20% of GDP to 40%, funded by a broader tax base. What is surprising about this book is how robustly the authors discount other widely held explanations for the gradual reduction in tax paid by the richest 1% since 1980. The influence of political lobbying, liberalised capital flows and the breakdown of the post-war consensus are, in their view, inadequate answers. What has changed is the focus on ‘equality of sacrifice,’ which has returned to a debate about fairness, a concept under which both ‘equal treatment’ and ‘ability to pay’ can coexist and compete on normative terms. Fairness can be invoked to defend taxes that are high or low; flat or progressive.

So in the light of the global financial crisis, the rise of Jeremy Corbyn, and the intensifying focus on the so-called 1%, what are the likely consequences for tax policy in the US and Europe?

Not much, say Scheve and Stasavage. In a 2014 study with YouGov, 2,000 US taxpayers were asked what they believed the marginal tax rate should be for different income levels. For those earning over $375,000, the median preferred rate was 30%, which is less than the 35% rate that is actually charged on incomes above $375,000 today. Even when respondents are informed of the scale of inequality in the US – which is significantly greater than many people imagine – their preferred rate of tax for top incomes does not change very much.

Despite the challenges thrown up over the last decade by the financial crisis, there is no clear evidence of a widespread impulse to bring down the rich. There is still an appreciation among many that wealth can be built by good work that improves society, and that sensible progressive taxation gets the balance right between ability to pay and equality for all under the law.

But that appreciation is not guaranteed to last. If there’s reassurance from this work that we’re unlikely to see the emergence of a politics of envy riding on the back of confiscatory taxes, there is a warning too that reinforces the urgency of reforming capitalism. We need to promote a popular, inclusive capitalism from which everyone can benefit; and a social contract that offers a level playing field, chances for individual fulfilment, social solidarity, and compassion for the less fortunate.

Public sentiment may change for the worse if the majority of taxpayers start to believe the economy is systematically rigged in favour of the rich in a way that is fuelling inequality. If electorates feel that too much of the burden of funding the state falls on low- and middle-income earners, especially in the form of indirect taxes, there could well be greater support for higher, compensatory levies on wealth and top incomes. If there is another banking crisis that calls on states to bail out failed actors, there would be calls for retribution. And if a perception grows that the rich not only benefit from favourable effective tax rates but also get special treatment by the state when it comes to building a successful career or business, or influencing political and social life, the public mood could easily sour during a future downturn.

The job for those who support the free enterprise system is to make sure that doesn’t happen.

By Hottinger Investment Management

A week after the UK posted negative Q2 economic growth figures, it was Germany’s turn for disappointing news. According to the Federal Statistical Office (FSO), Germany’s gross domestic product (GDP) was 0.1% lower at the end of June than it was at the start of April. Persistent weakness over the last twelve months means that the German economy is only 0.4% larger today than it was a year ago.

Softness in the country’s macroeconomy has been reflected within export-facing industries that are highly exposed to the global economy. Data from the Verband der Automobilindustrie reveal that annual production of passenger cars has fallen by more than a million units (from 5.8 million cars in mid-2017 to fewer than 4.8 million cars today).

The slowdown in China and the adverse development of the politics of international trade have hit German car-makers hard. According to ING, one quarter of all cars sold in China were German – with BMW, Daimler and Volkswagen relying on Chinese demand as the source of over one third of their total car revenues. Daimler has issued four profit warnings in recent times and Continental expects a 5% drop in global car production.

But it is not just car makers who are feeling downbeat; some of the country’s largest industrial firms have released warnings of some description. Chemical producer BASF has cut profit expectations by 30%, Henkel announced that it missed its Q2 revenue target, and Lufthansa announced that H1 2019 profits were €800m lower than the corresponding period a year earlier.

Even though Germany’s service sector is showing more resilience, the poor performance of industrials (down over 5% over the last 12 months according to the Federal Statistical Office, FSO) is a major issue for the country because this sector is a significant driver of German exports, which itself account for 47% of GDP according to the World Bank (considering imports, the excess of exports over imports amounts to around 7% of GDP). As global demand is a major determinant of a country’s export demand, and small economies such as Germany have little influence over global factors, the country must be willing to boost domestic demand if it wants to stabilise its overall GDP.

Fiscal policy is the best understood method of boosting a struggling economy. It involves deficit spending, where the government spends more than it takes in through taxes, usually by borrowing funds from investors in the bond markets. This should create additional demand that, in theory, percolates through the economy and reduces the effects of a slowdown on employment and wages. The problem is that the German political class has developed an almost allergic stance to deficit spending in recent years, exposing the economy to the vicissitudes of global trade.

In recent weeks, the situation moved into absurd territory with investors now willing to pay the German government to borrow for a period of a generation (or thirty years). It is worth putting this into context. The negative yield in 30-year German government bonds implies that the state could destroy resources and still make good on its debts, even before inflation is taken into account. At one-point last week, the 30-year yield fell to as low as -0.27% (See figure 1); this means that at this yield a €100, 30-year zero-coupon bond would generate funds of about €108.45 from the markets. With the government due to return only the €100 in thirty years’ time, markets are basically saying that the state can waste about 8% of the nominal funds that investors lend to it and ensure that the rest is only preserved – in nominal terms – over the holding period.

It is even more striking once one considers the effects of inflation. If the rate of German inflation averages 2% over the next thirty years, the government would in real terms have to return only half of what investors lend to it today.  It is an extraordinary situation,  yet the German government is still not taking advantage of it. Why?

The key factor is the law. In response to the rise in public borrowing after the global financial crisis, the then German government amended its constitution to introduce the Schuldenbremse (or debt brake), limiting structural deficits at 0.35% of GDP for the federal government and 0% for German states (Länder) after 2020. Article 109, Paragraph 3 of the Basic Law essentially forbids meaningful deficit spending unless it is caused by ‘cyclical’ factors, such as an economic downturn that pushes down tax revenues and raises payments on items such as unemployment insurance. As a result, public indebtedness in Germany has been falling rapidly over recent years (see figure 2).

The €50bn stimulus package that Finance Minister Olaf Scholz floated as a suggestion last week is therefore very much dependent on the economy first falling into recession and is in any case constrained by the 60% debt-to-GDP ceiling imposed by the European Union’s Maastricht Treaty and protected by the Schuldenbremse law. In other words, the spending pledge risks being too little, too late.

But this only shifts the question as to why the government won’t change the law to allow for structural deficits. There would be plenty of uses for deficit spending, whether it’s repairing roads and bridges, installing digital infrastructure, investing in schools, or getting the country retrained and retooled for the green energy transition whose first casualty could be Germany’s car manufacturers if it continues to rely on the internal combustion engine. The longer the country neglects areas in serious need of investment, the harder it will become for it to overcome the problems that such underinvestment will inevitably cause.

There is something else too. Structural deficits can be inflationary, and inflation is anathema to the key players in Germany’s political economy. Earlier in the year, Martin Höpner, a scholar at the Max-Planck-Institut in Cologne, published a paper on the history of what he calls Germany’s “undervaluation regime”. He describes how this regime started not with the euro but in 1944 with the Bretton Woods system of fixed global exchange rates, allowing Germany to run trade surpluses by keeping inflation low and its real effective exchange rate weak and thus competitive. A combination of German industry looking to expand into new markets, trade unions hoping to protect job security and the Bundesbank burnishing its low inflation credentials created conditions for the country’s strong position in global trade markets. Expansive fiscal policy, however, disturbs this equilibrium by generating upward pressure on wages via the public sector that can push corresponding wages in exports firms up too, thus reducing the export competitiveness in what is a very well-protected business sector.

A more challenging global environment may change this calculation. It appears that a slowing China, which is looking to source more of the capital goods that it has recently imported from Germany domestically, combined with political tensions that are negatively impacting global trade, could create serious problems for Germany’s export-driven accumulation model.

If these trends were to continue, Germany would have to start looking closer to home for sustained economic growth. That would mean deficit spending, which could have benefits for both Germany and the wider European region. Government spending would make up for years of under-investment and could provide conditions for the German economy to better face structural changes in the global economy – as it faces the rise of digital technologies and the transition to a low-carbon production model. If it raises Germany’s nominal GDP growth rate while keeping bond yields low, the deficit could effectively more than pay for itself (see figure 3). For Europe, higher domestic demand in Germany should raise demand for imports from other euro area states, and any higher German inflation that results could improve the competitiveness of those states.

The German government is starting to talk about stimulus and that is good. But the fear is that when it comes, it will be too little and too late.

By Hottinger Investment Management

During the second quarter of this year, the UK economy contracted for the first time since 2012. The Office for National Statistics (ONS) revealed earlier today that the British economy was 0.2% smaller at the end of June than it was at the beginning of April.

Market watchers have put forward a number of preliminary factors to explain this. One was the strong growth in Q1 due to the stockpiling of intermediate goods among manufacturers and other goods producers. Even if Brexit had taken place as planned at the end of March, the effect of this activity was always going to fall out of the second quarter’s figures as factories took their collective foot off the pedal.

The next factor is the state of the global economy. Some of the UK’s largest trading neighbours – including Germany and Italy – are seriously flirting with recession. Last week saw another dreadful round of factory data out of Germany and the Netherlands, and this follows disappointing numbers out of France, which hitherto had been seen as a bright spot.

The UK remains closely integrated into the European economy and will catch a cold whenever the old continent sneezes. It should be noted that even at the height of the British Empire and under the system of Imperial Preference that elevated – for example – the lamb of New Zealand over that of Spain, the European continent was often the UK’s single largest trading partner¹. Gravity is hard to suspend.

But the biggest factor has to be the Brexit uncertainty. For over a year, businesses have more or less stopped investing in the UK. In 2018, according – again – to ONS figures, growth in investment (or gross fixed capital formation) at 0.2% was the lowest in the G7 group of nations. This compared to an average annual growth rate in investment for the UK of 4% over the past twenty years. Lack of business investment has been contributing negatively to growth, leaving the consumer to carry the burden.

Consumers have been able to carry the burden because since the EU referendum, they have cut their savings ratio from 7% of GDP in Q2 2016 to 4.1% in Q1 2019. More recently, wages have been growing faster than inflation, providing tail winds for the consumer.

The obvious problem with this model is that it ought to be unsustainable. Higher inflation brought about by continued sterling weakness amid concerns over an acrimonious Brexit would suppress real wage growth. And there is only so far the household sector can cut its savings before dangerous financial imbalances build up among the subsets where income and wealth are lower. Household debt-to-GDP has steadily risen from roughly 85% of GDP during 2015 to above 87% today, according to figures from the Bank for International Settlements.

But there is an even bigger question of ‘sustainability’, involving the British economic model and its relationship with the rest of the world, which makes the outcome of Brexit a critical factor. For most of the period since the UK last saw a quarter of negative GDP growth, the country has run a current account deficit of more than 4% of GDP. This means, crudely, that for every £100 of resources that entities within the UK produce, those same entities (whether they are households, companies, banks or governments) consume £104, with the extra £4 arising mostly through an excess of imports over exports. It is where the phase ‘living beyond one’s means’ is most credibly used when describing the British economy, because the country has to borrow funds from foreign sources to pay for this excess. The question is whether this assessment is right.

Since the EU referendum, all domestic UK sectors (households, businesses and government) have been borrowing from the only foreign sector, the ‘rest of the world’. Whilst it is not surprising that the foreign sector is a net lender, it is highly unusual for a domestic economy as a whole – even one with a large current account deficit – to rely exclusively on foreign funding for its consumption. This is because the household sector is usually a net lender, providing funds to domestic businesses and government. But such is the current state of the UK that stretched consumers appear to be carrying the economy in the way that an airliner’s engine picks up the slack of its busted twin.

The source of this foreign funding is essential. If the source constitutes foreign direct investment or portfolio flows from non-UK citizens whose base currency is not sterling, then the UK is at serious risk of a sudden stop in funding in the event of a hard Brexit. The threat of a deep depreciation could then combine with a spike in inflation, a rise in interest rates and a cut in consumption in a manner which might push the UK into recession. This follows logically from the sectoral balances – whose elements must in toto sum to zero – if foreigners choose to stop lending to Brits. We may already be seeing early signs of this with the fall in sterling against both the US dollar and the euro in recent weeks.

However, given the rally in UK gilts in recent months, in line with the global search for safe assets, it is not obvious that this scenario will play out in the event of no deal on the 31^st October.

There is also an argument backed by research from the Bank of England that downplays the importance of this imbalance. It relies on the assumption that while ‘foreign funds’ are financing the domestic-facing UK sectors, these foreign funds are largely held by British citizens whose base currency is sterling. A fall in sterling would therefore increase the sterling value of the UK’s overseas assets. It would mean that the imbalance we see in the chart above could actually be sustained beyond Brexit.

If this story is right then we would then have to rewrite our story as one in which the UK is progressively running down its foreign holdings to fund the consumption of present resources. In practice, this manifests in asset owners liquidating their foreign holdings to fund either their own consumption or that of other British entities – whether households, firms or governments – through lending.

Notwithstanding the global situation, Brexit is a big factor behind the slowing UK economy. The question is whether further downside could yet come and how deep that could be. If the UK does head for a hard Brexit, the outlook for the country depends as much on who is funding the profligate British economic model as it does on the prospect of tariffs or regulatory barriers resulting from a hard Brexit.

¹ In most of the years between 1840 and 1880, Europe accounted for around 40% of the United Kingdom’s exports, a share that remained broadly stable as trade with other regions fluctuated. Sourced from Schlote, W. (1952) British Overseas Trade from 1700 to the 1930s.

 

 

 

By Hottinger Investment Management

July was the month in which markets started to get what they wanted from central banks. On 31^st July, the US Federal Reserve (Fed) delivered a 25 basis point cut to interest rates, the first of roughly four such cuts expected by investors before next spring.

Other central banks continued the soothing mood music, with the European Central Bank’s (ECB) Mario Draghi signalling rate cuts and renewed asset purchases and the Bank of Japan’s Haruhiko Kuroda committing strongly to stimulus if the global slowdown continues. By supporting liquidity, the Federal Reserve’s action has emboldened central banks in emerging market economies seeking to provide their own stimulus. The Central Bank of Turkey cut its benchmark one-week repo rate by 4.25 percentage points in July, from 24% to 19.75%, and signalled further cuts in the future. Brazil’s central bank cut rates by 50 basis points for the first time in a year, and in Indonesia and Russia rates fell by 25 basis points last month.

In financial markets, activity was mostly placid. The positive correlation between the total returns of stocks and bonds – rising share prices coinciding with rising bond prices – has started to break down. In July, the price of 10-year US Treasuries fell by 0.34% as the S&P 500 pushed higher by 1.65% over the month. Positive correlations are still strong in the UK, however: 10-year UK gilt prices rose by 2.31%, while the FTSE All-Share rose by 1.02%. UK 10-year government yields have fallen from 1.2% in May to 0.625% at the end of last month as investors – in the search for safer assets – shrug off British political instability and the likely resumption of deficit spending. Meanwhile, German bunds have consistently rallied since October last year, when the first signs of volatility on the back of slowing global activity emerged. Since then, the price for 10-year bunds has risen by 10.5%; in July prices rose by 0.9%. However, European equity markets were negative on the month with the Dax down roughly 3% and the Euro Stoxx 50 1% lower than it was in June.

European equity markets declined sharply, with cyclical sectors leading the fall due to unfavourable global trading conditions and the fading effects of the previous round of monetary stimulus from the ECB. With weak industrial production weighing on activity in Germany and Italy, investors looked to France and Spain to provide a boost to the Eurozone economy. However, French Q2 GDP figures were weaker than expected and confirmed to many that the region as a whole could be moving into a slower lane. Disappointing European earning results, along with Brexit concerns, also contributed to subdued returns from European equity indices.

It is not surprising, therefore, that we saw some evidence of a defensive rotation in the European markets. The only European cyclical sector that saw positive expansion was Consumer Discretionary, which saw price growth of 0.5% in July, according to MSCI indices. Industrials (-1.03%), Financials (-2.31%), IT (-0.95%) and Materials (-3.36%) all saw price declines. Conversely, the defensive sectors either held their own or saw modest gains: Consumer Staples (+2.55%), Utilities (+0.23%), Healthcare (+0.12%) and Telecoms (+0.25). The picture is less clear for the UK, which saw defensive sectors such as Consumer Staples (+2.96) and Healthcare (+9.25) rally, but Utilities (-2.33%) fall back. Ongoing concern over the prospect of a new government that could seek to purchase utility companies at unfavourable valuations continues to bear down on that particular sector.

At the end of July, Fed Chair Jay Powell described his rate cut as a ‘mid-cycle adjustment’ to address softening inflation and sentiment. Asset markets are behaving as if this assessment is correct. Both cyclicals and defensives expanded in the US; the MSCI’s US Technology index (cyclical) and its Consumer Staples index (defensive) rose by over 3%. We think that the US economy is actually in late cycle, a period of the economic cycle where the growth rate of the economy is positive but falling before turning negative. Slower growth means that company earnings are less likely to meet investors’ expectations, raising the likelihood that share prices will fall. We are concerned that the implied earnings expectations priced into valuations are ambitious given the current macroeconomic environment.

Despite the move to ease monetary policy in the United States, the US dollar index strengthened by 1.73% against a basket of other developed currencies. Of particular interest has been the performance of sterling, which weakened by 3.82% against the dollar and 2% against the euro. Concern over the new British Prime Minister’s comfort with the prospect of leaving the European Union with no deal has forced sterling down at a time when wage growth and consumer spending are strong and the Bank of England is more reluctant than others to engage in monetary stimulus. 

Further, the gold price (up by 1.9% in July) has been boosted by central bank purchases as these organisations reduce their exposure to US dollar reserves due – in large part – to the unresolved trade stand-off between the US and China and the risk of politicisation of the Federal Reserve.

In a late-cycle environment, real assets can be more attractive than credit products, and it often pays to take some equity risk off the table. While bond yields are low, the rally in this asset class could have some distance to run. We will keep an eye on this as the short-term benefits of capital appreciation could offset the low or negative yield over the holding period.

By Hottinger Investment Management

A new conventional wisdom has emerged in recent weeks among people who want the equity bull market to run on and on, and it goes like this: The rally in global bonds and race to loosen monetary policy may be reactions to slowing global trade and activity passing through to sluggish earnings, but this does not mean that the great bull market in equities must come to an end. On the contrary, this view holds that lower bond yields boost valuations and should allow the party to keep going.

Usually, when central banks cut rates it is because economies are in ‘late-cycle’, which means growth starts to slow and company earnings soften. It is usually too late for central banks to stop this deceleration and their cuts to interest rates often kick in only once the economy is in a state of recession. Equities therefore typically fall as rates go down, which is evident in the charts below for two periods in the 2000s. In other words, during ‘late cycle’, there is a negative correlation between the total returns of bonds and equities.

People who hold this view are implictly saying that the positive correlation between total returns of stocks and bonds – something we have not seen much during the period of independent central banking – could be here to stay. They could be right. Although we are not convinced, it is worth mentioning four reasons which may support their case. While they may not be right today, they could be in the not-too-distant future.

The first is that recent US history shows rate cuts can coincide with sustained expansion in US equity markets. When the Federal Reserve cut rates in the mid- and late-1990s, first amid concerns of growth slowdown and then to fight any contagion from the Asian financial crisis and the Russian debt default, equity markets continued to rally. In 1995, the then Fed Chairman Alan Greenspan spoke of ‘insurance cuts’: pre-emptive reductions in interest rates to engineer a soft landing for economic growth. It seemed to work; it wasn’t until 2001 that the US next experienced a recession.

We could be in a similar situation today. There is again talk that the Fed will make an ‘insurance cut’ later this month and at least one more in the Autumn, but markets want four such cuts by Spring next year.  As in 1995, when Greenspan speculated that US inflation was “being held down by events in the rest of the world,” today global factors – emanating in China in late 2017 before passing through Europe last year – have acted as headwinds to an American economy that has been growing at above 3% per year for a considerable period of time.

A bout of monetary easing could reveal a US economy that remains resilient to global factors, one that is mid-cycle rather than late-cycle. The Fed would then have successfully permitted the party to go on. Many, however, are skeptical that the US economy has been immune to global events – particularly the trade war; US corporates that have high revenue exposure to China have performed relatively poorly in recent months.

A key reason for the global slowdown reaching the US last is the country’s unconventional fiscal policy – with the Trump adminstration presiding over a pro-cyclical fiscal deficit that recently exceeded 4% of GDP, according to the US Congressional Budget Office. Unconventional fiscal policy is the second factor that could support the idea that equity markets can stay strong as interest rates and bond yields fall.

Fiscal-monetary coordination is a dry phrase describing a concept that is in vogue within international policy-making circles.  Most notably, President Trump has been keen to politicise the Federal Reserve’s activities through the medium of Twitter, but the idea that central banks should work with government treasuries is one that is popular among serious policymakers too.

The incoming ECB governor, Christine Lagarde, has previously spoken about the need for fiscal-monetary coordination. She will play an important role in encouraging European governments to spend more and persuading EU institutions to let them do so. What this means is that lower interest rates could provide the fiscal space for governments to spend more as they would be able to borrow more cheaply. Extra spending could then translate into stronger nominal GDP growth that feeds into earnings and valuations. In this scenario, share prices would rise. We have previously argued that such a switch to policies of ‘fiscal dominance’ could drive inflation in a way that means that stocks and bonds move in the same direction.

The third reason supporting the equity bulls lies in the possibility that central banks will in the future support equity markets directly. There has been speculation that in the event of a serious downturn, central banks may directly intervene in the equity markets by taking stakes in public companies. The Bank of Japan has already implemented such a policy, last year purchasing 5.6 trillion yen ($50bn) in Japanese equity ETFs, taking its total ETF balance to around $300bn. The central bank aims to use ETF purchases to stoke inflation by spurring gains in asset values, as well as promoting active private consumption.

We are not convinced that outright direct equity purchases do more than just aggravate inequality, but governments could design sensible equity purchase policies where their central banks would buy equities when they have suffered a drawdown, sell them as the market recovers and distribute the gains to the public ahead of the next downturn. The point, however, is that this policy would support an environment where rising equity prices could coincide with falling bond yields, as the central bank would be active in both markets.

Lastly, the Federal Reserve is arguably the world’s central bank. Anyone who has read Crashed by the peerless Adam Tooze can appreciate how it was the Fed, not the ECB, which bailed out European banks during the 2008 crash through its liberal supply of dollar swap lines. The Fed’s interest rate policy is also closely tracked by a great many emerging market economies, whether or not they peg their currency to the US dollar.  

Last year, economists Matteo Iacoviello and Navarro Gaston studied the global transmission of the U.S. Federal Reserve’s interest rate policy and what they found was striking. Looking at macroeconomic data covering the period 1965-2016, they found that the effects of monetary tightening from the Federal Reserve on economic growth are almost as strong outside the U.S. as they are within it.

“A monetary policy-induced rise in U.S. rates of 100 basis points reduces GDP in advanced economies and in emerging economies by 0.5 and 0.8 percent, respectively, after three years. These magnitudes are in the same ballpark as the domestic effects of a U.S. monetary shock, which reduce U.S. GDP by about 0.7 percent after two years.”

The authors explain the transmission of US policy worldwide as occurring through standard exchange rate and trade channels, with countries that trade with the US and manage their currencies in line with the dollar more strongly affected. As US rates rise, the dollar appreciates. In countries for which a stronger dollar causes inflation to rise or balance sheets to deteriorate, or where the government has tied its currency to the dollar, there is pressure for interest rates to rise too. As the experience of 2018 showed, emerging market countries with exposure to the dollar, current account deficits and low foreign reserves – such as Turkey, South Africa and Argentina – can be severely constrained by tight U.S monetary policy.

Certainly, then, lower US bond yields and interest rates can be very positive for dollar liquidity in emerging markets (EM). They can support  EM companies’ balance sheets and ultimately asset prices too. Given the growing weight of EM in global markets, there could be positive feedback for US equities too.

So, there we have it. The equity bulls may be right, but we think the rally in global bonds is more likely a reflection of the hard economic data pointing to a moderately slowing world economy, which should be negative for equities as earnings fail to meet ambitious expectations. In time, therefore, equities should come down even as interest rates do too.

However, there are good reasons to suggest that investment dynamics could change in favour of equity bulls over the longer term, but only if the political-economy environment changes too: If the policy regime changes to one involving deep fiscal and monetary coordination, if central banks start directly supporting equity markets, or if emerging markets increasingly become dependent on dollar liquidity delivered through a low interest rate policy from the Federal Reserve, the picture could look very different.

By Hottinger Investment Management

Last week, the Italian treasury issued €3bn in 50-year bonds. According to Reuters, the issue drew over €17bn of bids, 80% of which were from foreign investors, with Germany the single biggest source of capital. The final yield came out at 2.877%.

International interest in Italian bonds comes in the context of a general scramble for government bonds amid fears of a widespread global slowdown. In the belief that interest rates are broadly coming down and the ECB will stand behind Italy’s public debt, investors appear to have parked their concerns about Italy’s political situation.

Last May, Italian 2-year yields spiked above 2.7% and 10-year yields rose to over 3.5% in the following months as the Italian government threatened to break the EU’s budget rules in order to increase public spending. Even though Italy’s de-facto leader Matteo Salvini and others in his administration have since toned down their rhetoric, it is hard to make the case that Italian public debt is now a safe asset. Investors may come to regret piling into global government bonds generally and Italian bonds specifically.

Who can blame the Italian debt management office for capitalising on the great rally in global bonds? Academic research by Martin Ellison and Andrew Scott finds that issuing long-dated bonds actually costs most governments more over the long-term compared with rolling over shorter-dated bonds as they fall due. This is because the premium that investors charge for duration risk, combined with the fact that we live in an environment in which central banks have anchored inflation at low and stable levels, amounts to a subsidy from the government to investors. Italy, however, is a different case and we should ask why the country might be interested in issuing more longer-duration bonds.

Issuing large amounts of very long-dated debt only really makes sense if you cannot rely on the market to offer you stable short-term rates, if you are planning to announce a big spending programme and do not want refinancing costs on your existing debts to rise, or – more perversely – if you are intending to generate a bout of surprise inflation in the future to reduce the real value of the debt you have issued. This last reason does not really apply to Italy because it does not have control over its money supply and – as a member of the eurozone – it has only a limited ability to generate inflation in its own country independent of the European Central Bank.

Nevertheless, this lack of independence makes the situation for Italy quite interesting. Italy currently carries a debt-to-GDP ratio of over 130%. That ratio is high not because the Italian government has been feckless in recent years; in fact, since the early 1990s, in every year except 2009, Italy has run a primary budget surplus. Italy’s problems lie in the fact that it built up huge debts in the 1960s and 70s as it expanded its welfare state; since then, it has simply rolled those debts over rather than paying them back. Italy has had difficulty repaying legacy borrowing as economic growth and inflation have struggled to exceed the rate of interest that investors charge on bonds. Even today, Italy’s economy is still smaller than it was in 2008 and not much larger than it was in 2001. The German economy, by contrast, is over 50% bigger than it was at the turn of the millennium.

With Italian growth anaemic and the ECB conducting a monetary policy that is too deflationary for the country, Italy’s indebtedness is a problem for markets, which tend to react sensitively to developments in Italy’s economy and politics, quickly repricing Italian debt. It is also problematic for the Italian government, as high legacy debts constrain its ability to vary fiscal policy, either according to movements in the economic cycle or according to structural requirements such as the need to invest in infrastructure and education.

It therefore makes sense for the Italian government to reduce its reliance on short-term debt as it cannot know in advance whether maturing bonds will come due in a period in which the markets have very little confidence in the Italian economy and the Italian government wants to spend more money – such as during the euro crisis. Issuing longer-dated bonds can therefore reduce repricing risk and thus default risk.

Even still, it is costly. The 2.8% yield on the 50-year bonds is a little above the peak of the spike in 2-year yields, which occurred after the announcement of the Italian government’s intentions rapidly to increase spending in May 2018. So, the second and third justifications for issuing long-dated debt also still stand: future spending and higher inflation. If the Italian government is secretly preparing a large fiscal stimulus or thinks that an Italy-friendly ECB will generate inflation that exceeds the spread between 50-year and 2-year bonds, then the Italian government will benefit from issuing long-dated bonds. This is because, in the first instance, markets will have less ability to punish Italy for pushing its debt level higher by increasing interest rates; and in the second instance, the eroding effect of higher inflation will help bring down Italy’s debt burden by forcing real-terms losses on long-term bondholders. If any rise in public spending pushes debt beyond sustainable levels, then long-term bondholders could face capital losses as the risk of default and haircuts rises.

It is too much to infer intentions from relatively small issues of long-dated debt, but if this trend continues as other existing bonds mature in the coming months and years, alarm bells ought to start ringing among the foreign investors who are piling into Italian debt today in the search for ‘safe’ assets. The expectation that a dearth of safer German bunds will force the ECB to hold more Italian bonds in any future round of quantitative easing is not the strongest insurance against any possible long-term erosion in the real value of Italian sovereign debt.

The narrowing of the 30yr-2yr spread appears to suggest that investors are more comfortable in Italian bonds that mature well into the future, or at least after the passing of the current, populist administration. They appear to be less concerned about long-term Italian inflation and debt dynamics than they are about the risk of a sudden re-emergence of a budget crisis in Italy. With 10-year bonds now yielding less than they did before the Italian government took on the EU over public spending whilst 2-year yields are still above their pre-event levels, one could argue that shorter dated Italian debt continues to carry a small risk premium.

We think there is also a general possibility that this global bond rally is a bit overdone. Investors are scarred by the financial crisis and have seized on the link between the ongoing trade tensions and slowing global manufacturing as foreboding a global recession à la 2008. If we learn that at worst, any coming recession will be shallow and that at best fundamentals are still actually okay, then all those who are piling into bonds today could quickly get burned. This applies to Italy too, but the more pressing concern is an escalating political disaster that pits Italy against the EU in a future crisis over its budget. In that situation, investors who are scooping up 50-year Italian debt at under 3% may come to regret it.

By Tim Sharp, Hottinger Investment Management

The S&P 500 has had its most successful half year since 1997, rising 17.35% following signals from Fed Chairman Jay Powell that the Federal Open Market Committee (FOMC) is on the verge of a rate cutting cycle. Based on 12-month earnings estimates, the index is trading at 17x, vs its 10-year average of 14.8x, last reached just before the sell-off in 2018. This shows that upward revisions in earnings have not been forthcoming, as Philip Georgiadis reported today in the Financial Times.

Markets have been pricing in more aggressive monetary easing from the Federal Reserve, as indicated during the June FOMC meeting mid-month, when Powell was quoted as saying “an ounce of prevention is worth a pound of cure”. The S&P 500 gained 6.89% on the month, leaving the Euro bloc (4.93%), the UK FTSE 100 (3.68%) and Japan’s Nikkei 225 (3.27%) languishing in its wake. Markets now expect three or four 25bps rate cuts by the end of December, which may mean a cut at four of the next five meetings of the Federal Reserve Board. Despite falling inflation in the US providing cover for rate cuts, the Committee expressed scepticism about the likelihood of the expected 100bps in cuts happening, which, if it turns out to be well-founded, could cause a tanrtrum in equity markets and a rise in bond yields.

The move by markets to expect central banks once more to bail out risk asset markets was matched by the European Central Bank (ECB), indicating that further stimulus could be forthcoming. Regardless of whether investors bought equities, corporate bonds, developed market government bonds or indeed gold, the latter of which rallied 7.96% to $1409/oz, these investment decisions would have yielded a positive return in June. The threat of lower rates in the US pushed the dollar index down 1.66%, which partly explains the rise in gold and the strong performance from emerging market equities, which were up 5.70%.

This leaves the financial markets with a dilemma as to whether the global economy is in late cycle or indeed mid-cycle. This is because the timing of the next round of stimulus will either catch the falling global economy and keep the expansion going, or it will merely soften the effects of the weaker environment now showing itself but fail to prevent an economic downturn. In line with research from Morgan Stanley, we think that interest rate cuts in late cycle will likely coincide with declines in equity markets shortly afterwards. Central banks often overshoot with rate rises and these take time to work their way through the economy; by the time the rate cuts come through, the economy is often in a slower gear. If, however, we are mid-cycle, rate cuts – such as those seen in the 1990s – might actually support equity markets.

Global manufacturing Purchasing Managers’ Indices (PMIs) remain suppressed, as hard data on shipping volumes and inventories suggest that global trade is slowing. Export and import growth in China has dimmed, and European industrials in major exporting countries continue to disappoint despite a brief glimmer of hope in April. Notwithstanding a boost to the US growth outlook through retail trade and industrial production prints, the country is unlikely to sustain the current 3%+ annualized rate of growth.

The extent of the effect of the US-China trade war on the global economy became more evident in June with the release of global manufacturing statistics. Manufacturing surveys around the world have been falling – most notably in the US, China, Japan and Europe – leaving global new orders at the lowest point on record and business optimism pointing to falling output. South Korea, often used as an indication for the global market, saw exports fall year-on-year by the biggest margin for 3 years. In the UK, the PMI data fell to 48 in June vs 49.4 in May, the lowest level since 2013, suggesting a fall in output for 2 consecutive months. Many industries are suffering from the continued Brexit hangover as inventories are run down after the build-up prior to the original leave date in March, but many are also pointing to continued weakness in global export markets.

The UK continues to be dominated by the Brexit narrative and the Conservative leadership campaign that will decide the next Prime Minister before the deadline to leave the EU on 31 October. It remains to be seen whether and how either candidate will be able to negotiate a deal with the EU, persuade Parliament to leave without a deal or indeed unite the Conservative party to solve the impasse. Effective government has largely ceased in the UK, so companies will be relying on the Bank of England to join the central bank moves to add further stimulus to reinvigorate the economy. Uncertainty saw the pound fall back into negative territory for the year in June, weakening -0.65%, and gilts were unchanged despite the rally in sovereign bonds in other developed countries.

The G20 meeting on the last weekend of June saw the US and China agreeing to continue trade talks with no escalation in tariffs, taking away the immediate fears of financial markets, with the added good news that the US softened its rhetoric surrounding the security questions of trading with Huawei. The ongoing uncertainty will continue to weigh on sentiment, but we can expect short-term relief that the can has been kicked a little further down the road.

We join the many investors who have decided to wait and see whether central bank policy manages to reaccelerate global growth or fails to prevent it slowing further, which will offer an indication as to how late in the economic cycle we currently find ourselves. Equity valuations are elevated and US 10-year bond yields have reacted to the Fed’s comments by dropping from 2.26% at the end of May to 2% by the end of June, as asset classes once more become correlated and some traditional relationships break down. A rate cut in July is likely, which should provide opportunities for profit-taking, however the longer-term outlook from the Fed meeting should really inform the global picture for the second half of the year.

By Hottinger Investment Management

 

There has been a rise in interest in what one might ordinarily consider to be a mundane subject: the correlation between stock market returns and bond returns. It is an important topic because portfolio asset allocation since the turn of the century has been built using assumptions about the correlation between market movements in stocks and bonds that are beginning to look a bit weaker. If these assumptions break down, then the consequences for investment strategy and performance could be profound.

First, we must be clear on the concepts because it is easy to get confused. Analysts often use terms such as prices, returns and yields inconsistently when talking about correlations between stocks and bonds. When thinking about the subject, one should therefore bear the following in mind:

1. The price of a fixed coupon bond is always negatively correlated with the yield of the bond. A more expensive bond “yields” less as the interest payments (or coupons) are usually fixed against, in this example, the higher cost of purchasing the bond. Exceptions may apply to inflation-linked bonds, where higher inflation could raise coupons and therefore yields in a way that attracts demand from investors that pushes bond prices higher.
2. The total return of a fixed coupon bond is always positively correlated with the price of the bond. The total return of a bond comprises both interest income received from the bond and any gains or losses in the capital value of the bond, measured by its price. Interest income is often – and confusingly – referred to as yield, but – as explained above – this is usually a fixed amount determined in advance of purchase.
3. The total return of an equity comprises both dividend income and any gains or losses in the capital value of the equity, again measured by its price. The total return of an equity is usually positively correlated with the price of that equity unless companies explicitly tie their dividends to share price performance.

So if, for example, an analyst says that stock prices are negatively correlated with bond yields, they are almost certainly also saying that (i) stock prices are positively correlated with bond prices and (ii) total stock returns are positively correlated with total bond returns.  

Analysts have been studying the long-run stock/bond correlation data and believe that an important recent trend is coming to an end.

As Figure 1 shows, during most of the period since 1937 in the United States, the correlation in total returns has been positive, meaning that neither asset class offers protection from poor performance within the other. However, since the late 1990s, the correlation between total returns of stocks and bonds has been sharply negative, supporting a popular portfolio allocation model that puts roughly 60% of capital in equities or stocks and 40% in bonds. This is done with the expectation that when one asset class performs badly, the losses can be capped by stronger performance in the other asset class.

Alternative data series show that strong positive correlations in total returns were the norm not just in the U.S. but also in developed economies going back to the 1800s before turning negative in the 1990s. However, this era of negative correlations may be coming to an end everywhere.

Our view, shared by others in the investment community, is that the period of negative total returns correlation has a proximate cause in low inflation, which the US has experienced since the late 1990s. We think the causes of low inflation are central bank independence – which only really took hold in the late 1990s and early 2000s – and weak bargaining power of labour, which is a trend that goes back to the 1970s. The share of national income in the US (and other developed economies) to wages has fallen from about 52% in 1970 to about 43% today, according to the Bureau of Economic Analysis.

In the last 20 years, monetary policy has prioritised low inflation and has typically taken the lead over fiscal policy when economies slow down or move into recession. It makes sense, therefore, for bond prices to rise as stock prices fall in the period before a recession as central banks prepare to cut interest rates. And it makes sense for this to unwind as economies recover. With anti-inflation central banks keeping a lid on demand and fewer opportunities for labour to push for higher wages, inflation has recently barely registered as a factor compared to how it has done throughout most of the rest of post-WW1 history.

Take, for example, the 1960s, the only period on historical record during which the correlation flipped from negative to positive. CPI inflation rose from around 1.2% in 1964 to 5.5% in 1969. According to Federal Reserve Economic Data, over the whole five-year period between 1965 and 1969, US 10-year Treasuries returned just 0.06%, a strongly negative real return given the high inflation. The S&P 500 returned 27%, which was not significantly more than the cumulative inflation – of 19.7% – over the period. Inflation may have affected both asset classes negatively; in the previous five-year period between 1959 and 1963, the S&P 500 returned 59.2% and US Treasuries rose by 19.2%. As both bonds and equities struggled together, the correlation between the two became positive and the historical 10-year correlation as shown in Figure 1 steadily rose. 

This may have been a singular case, but it is worth investigating whether there are any lessons for today.

Populist demands for a higher share of national income to be reallocated from capital to labour could create a structural shift which, combined with inflationary pressures, would push down returns across asset classes as higher labour costs cut into companies’ margins.  This appears to be what happened in the 1960s. Unemployment was below 4% – as it is today – which is considered a level that represents a tight labour market and raises the risk of wage-inflation.

This is a view developed in some detail in a recent paper by Marco Pericoli for the Bank of Italy¹. In it, Pericoli claims that before the 1990s, inflation and economic growth were negatively correlated as it was typically supply shocks that pushed up costs and brought about recessions. He found that in the stagflation period of the 1970s to 1990s, “good” news regarding future cash flows to equity was correlated with lower expected future inflation; in other words, supply factors such as labour or input costs were driving inflation higher and hitting company margins. Since 2000, however, inflation and economic growth have been positively correlated as demand shocks have driven the business cycle.   

Equally, populist demands for more active fiscal policies could generate higher wage inflation during stress periods for the economy. If wage inflation rises in response to a fiscal stimulus, stocks could fall as costs rise; bonds would be hit by higher price inflation. Therefore, total returns for bonds would tend to move in the same direction as total equity returns.  With increasing demands for fiscal stimulus at a time when unemployment is at record lows, it is not surprising that the stock/bond total return correlation is moving back towards positive territory.

The implications for asset allocation are potentially significant. If total returns between stocks and bonds stop offsetting each other, then the justification for running portfolios around the 60/40 model of roughly equal weightings to equities and bonds will start to fall away. Attention then ought to turn to judging each asset class on its own merits and allocating capital according to attitudes to risk and tolerance for drawdown. This may well be good news for active asset allocation and bad news for those who are simply resting on their laurels.  

¹The paper also shows that the trends for historical stock-bond correlations apply for other developed economies such as the UK, France and Germany.

By Hottinger Investment Management

Investors are not impressed with Europe’s escape from near-recession. Traders have pushed down the Forward 5y5y Inflation Swap Index, a proxy for future expectations for inflation, towards 1% this week. This is the lowest level for inflation expectations since at least 2004 and reflects the rally in several European government bonds, including the sovereign paper of Italy and Greece.

The movement has, at best, shot to pieces the ECB’s hope that the market would take the reversal of QE and higher interest rates in its stride. At worst, it suggests that the ECB’s Governing Council may have to start thinking creatively about the next round of stimulus, starting from the unenviable position in which interest rates are already negative.

We have previously argued that Europe’s manufacturing sector has been at the heart of the region’s weakening economy as a slowing China and trade tensions weigh on global demand and exports. It appears that despite some good news in recent months, the European economy remains highly sensitive to global developments and this is what is causing concern among investors.

Last week, Germany’s Federal Statistics Office announced the biggest monthly fall in German industrial production in four years, with factory output in April 1.9% lower than it was in the previous month. Shortly after the German industry report, the Bundesbank issued its latest forecast for the economy, cutting its 2019 prediction from 1.6% to 0.6%.

According to Eurostat, during April eurozone industrial production shrank at a month-on-month pace of 0.5%, a greater rate than the consensus of -0.3%. Among the bloc’s other economies output was weaker in the Netherlands (-1.7%) and Italy (-0.7%) while in France (0.4%) and Spain (1.7%), it was higher. However, compared to a year ago, industrial output across the eurozone is 0.4% lower.

Export-facing categories of goods have fared particularly badly. Output of durable consumer goods was the weakest, shrinking by 1.7%, followed by a decline of 1.4% in the production of capital goods such as factory tools and machinery. With the euro area building up a large trade surplus to recover from the region’s extended financial crisis, there are renewed fears that weaker exports could infect the domestic economy and its services sector, which have so far shown a resilience supported by strong real wage growth and falling unemployment.

So what can the ECB do? In recent weeks, Mario Draghi has talked about targeted long-term refinancing operations or TLTROs. These are loans that the central bank offers to commercial banks at attractive rates on the condition that they use the resources to lend these funds on to the real economy. We have previously argued that TLTROs as currently designed are somewhat impotent. The implicit subsidy in the TLTRO lending rate of -0.4% is not large enough to incentivise big increases in lending to the kind of risky economic projects that generate growth. Chronically weak productivity growth and soft demand in the eurozone mean that banks struggle to find good ventures with an acceptable level of risk.

Eric Lonergan, a macro fund manager at M&G, has been promoting a novel tweak to TLTROs that would turn one of the central notions of banking on its head. The first principal of banking is that the bank charges a higher interest rate on its loans than it pays on its deposits, generating revenue on the spread between these two rates.  Central banks such as the ECB replicate this idea by setting their deposit rate below their borrowing (or refinancing rate).

Lonergan’s suggestion is that central banks flip this order, lending to commercial banks at steeply negative rates and allowing them to deposit reserves at zero or positive rates. The ECB could introduce simple rules to prevent churning (i.e., redepositing borrowed funds) by requesting that, similar to the rules for TLTROs, any borrowed funds be on-lent to the real economy. Such an idea is radical and amounts to potentially a huge subsidy to commercial banks. If the ECB set a sharply positive deposit rate, the central bank would be subsidising consumers too if the ECB were to request commercial banks pass the returns to savers. Lonergan considers this as a ‘dual interest rate’ policy, where the central bank sets two interest rates and allowing them to diverge from one another at certain parts of the cycle. 

The idea is interesting but is not without its problems. Sharply negative rates potentially encourage speculative bubbles and by subsidising possibly unproductive projects they could lead to a waste of resources. However, such an idea could go far in re-establishing the ECB’s credibility at a time when inflation expectations are falling and the ECB’s Governing Council is flirting with the appointment of perma-hawk Jens Weidmann as its leader.

Conversely, a Weidmann ECB could ensure that Lonergan’s dual interest rates idea never gets off the ground. If so, the Eurozone could be more reliant on fiscal stimulus than ever before. 

By Hottinger Investment Management

As we discussed recently, we have seen signs in the last couple of months that the global economy may have put the recent slowdown in activity behind it. Shipping volumes have picked up after cratering towards the end of 2018. There has been a big rise in Chinese export orders, which bodes well for Europe. The US dollar has remained strong, dampening the appeal of emerging markets as the Federal Reserve’s feet-dragging on rate cuts keeps the dollar attractive for global investors.

Leading economic indicators out of China have turned positive. According to the World Steel Association, China’s crude steel production for April 2019 was 85.0 Mt, an increase of 12.7% compared to April 2018, the fastest rate of growth since at least November 2017. Inventories of iron ore fell by almost 20% between mid-April and mid-May, possibly suggesting increased demands from industrial companies.

However, there are some signs of negative pressures. The CSI 300 index of leading Chinese stocks has struggled despite a good start to the year. We have also seen that MSCI World companies with high revenue exposure to China – especially semiconductor producers – have become more volatile as the trade war between the US and China intensifies, and they performed particularly badly last month.

In Europe, domestic factors have withstood the headwinds from a challenging global trading environment. Strong wage growth of 2.3% has been in excess of inflation and has therefore undergirded consumer spending and the domestic-facing industries. However, signs of strength may be misleading. The most recent German sales figures show a decline on the month (although still 4% up on the year).

We have discussed possible opportunities for value investing in Europe, given the attractive valuations of such stocks. Research suggests, however, that periods of value outperformance do occur but can be short-lived. Where they occur and persist, this is due to supportive macroeconomic policies that prioritise full employment over inflation control.

Therefore, with inflation expectations in the Eurozone trending towards 1% as measured by the 5y5y forward inflation swap, and with the prospect of a hawkish ECB governor following Mario Draghi later in the year, we don’t see conditions in which the long-favoured return of European value outperformance can be sustained, if indeed it happens at all.

We note that the market is pricing in 40bps of rate cuts in the US by the end of the year, the most aggressive expectation for monetary easing in this cycle. The Federal Reserve, however, remains neutral and will continue to respond to economic conditions. With core inflation falling in the US, growth and consumer spending decelerating, retail and auto sales weakening, and companies refraining from investing due to fears over the international trade, there is good reason to think that the Fed will comply with the market’s demands. However, it is moot whether the Fed will fully comply and cut interest rates twice this year, especially if inflation rebounds or is pushed higher by the effect of China’s retaliatory tariffs.

If the Fed fails to meet market expectations, negative sentiment could emerge and affect US equities, especially in the “Cyclicals” segment of the market, which has outperformed the “Defensives” segment in the last couple of months.

Nevertheless, the US remains an attractive market. The dollar is strong on a trade-weighted basis, defying market predictions for a move downwards. Persistently high relative US interest rates, coupled with America’s deep and broad capital markets, have kept the dollar strong. We have also seen that US markets have outperformed other global developed markets even once the popular Technology sector companies have been stripped out of the S&P 500 index.

In the UK, we discussed how the flattening gilt curve seems to be impervious to domestic political risk, possibly reflecting a global trend towards fixed income products with 10-year gilt yields falling in line with German bunds and US Treasuries. The yield on German bunds has fallen to record lows below -0.2%.

However, our view is that with the situation in UK politics as it is, there could be considerable downside risk to buying long-dated gilts. We also believe that while there may be a significant value discount in UK equities, high payout ratios (implying low investment rates) and low dividend growth rates represent headwinds. Nevertheless, we think that sterling remains at a discount to fair value, especially against the US dollar and a favourable resolution of the Brexit question later this year will on balance provide impetus for the currency to strengthen towards its long-run median level.

By Harry Hill, Hottinger Investment Management

May 2019 marked another month in which markets were more driven by political noise than by fundamentals, however, that’s not to say that fundamentals were completely ignored.

As Theresa May handed in her resignation effective June 7^th, Donald Trump fuelled the fire by slapping further tariffs on the Chinese and surprised markets with 5% tariffs on Mexico in his latest attempt to curb ‘illegal aliens’ crossing its territory. May was therefore an eventful month to say the least. Global equities were down 5.66%, making May the first month this year that has exhibited negative returns. The VIX, a measure of volatility, reached a 4-month peak at 20.55, which compares to a broader average of 15.8 since January.

Theresa May’s departure announcement did not come as a huge surprise, but the uncertainty around her successor, the likelihood of a general election and the possibility of a no-deal Brexit outcome have had noticeable effects on the currency market.  The currency movements of sterling demonstrate investors’ indecisive predictions surrounding Brexit. The depreciation of sterling began on the 3^rd May at $1.317, following the collapse of cross-party Brexit talks and the results of the UK local elections, which saw big losses by the Conservative party. The GBP-USD rate currently sits at $1.267.

Unlike the aftermath of the 2016 referendum, depreciation in sterling no longer proves to be the tailwind it once was. The FTSE 100 fell 3.5% in May, which is counter-intuitive given that a large portion of these companies’ incomes are repatriated from overseas and as such should feed through to enhance bottom-line growth. This move reflects broader concerns about policy changes such as re-nationalisation of utilities should Labour win a general election.

The UK 10-year gilt started the month yielding 1.15% but has subsequently fallen to 0.87%. This is more of a flight to safety trade given the political environment and a broad consensus that interest rates will remain stable at 75bps until the Brexit situation has been resolved. The 10-year gilt will likely remain a safe haven, with longer-dated bonds at risk of inflation – even more of a risk now given the currency depreciation. 

Meanwhile, overseas the spat between the US and China continues. Donald Trump raised tariffs on $200bn worth of goods from 10% to 25%. The tariffs have so far slowed global trade and reduced business confidence as corporations hold back from investment. Purchasing Managers’ Indices (PMIs) in the US, EU and Japan all continued their downward trend, suggesting a sluggish outlook for manufacturing. Whilst the current figures are not a material cause for concern, any additional policy potentially used in retaliation, which may include non-tariff measures such as discouraging consumers from buying US goods, could be worrying.  Ironically, US exports to China are down 30% year-on-year compared to Chinese exports to the US, down only 13% year-on-year. Should the talks escalate, Donald Trump has threatened to impose tariffs on all Chinese imports, covering over $530bn of goods.

Politics aside, labour markets and consumer sentiment continue to be strong with modest fiscal support in China and Europe, whilst the US Federal Reserve remains dovish. Data for the month of May showed encouraging job growth in the US, EU and Canada. Europe continues to be heavily reliant on export demand from China, so it comes as no surprise that it has been caught in the crossfire between US-China trade talks. Risk asset valuations look reasonable at current levels following negative returns over the month, compared to a rally in sovereign bonds across the developed world (except for Italy). US Investment Grade and High Yield spreads widened by 15bps and 75bps respectively, according to JP Morgan, reinforcing the move into low risk assets. Most major developed markets ended the month down 5%-8%, with technology stocks leading the decline. Defensives outperformed cyclicals.

Performance during May was undoubtedly driven by political headlines, namely Brexit and US-China talks. Volatility is unlikely to go away and as bonds continue to deliver a negative real yield, investors will continue to look to risky assets for returns.

By Economic Strategist, Hottinger Investment Management

The last few weeks have seen a slew of promising news about the world economy. In the UK, first quarter GDP growth, at 0.5% (or approximately 2% annualised), surprised on the upside. The US confounded analysts by putting in another quarter of more than 3% annualised growth. Italy exited technical recession and Germany returned growth of 0.4% during Q1.

In Europe, output has recovered on the back of resilience within the domestic-facing sectors of the economy, as retail sales and services take up the slack from a manufacturing sector that has struggled to deal with a challenging global environment over the last six months. Wage growth has exceeded inflation and unemployment – by European standards – remains low.

As Figure 1 shows, China has been leading the global economic cycle for the last seven years. Movements in important leading indicators of output – such as overseas orders, steel production and consumer confidence – have tended to run ahead of their US and European counterparts.

During 2018, Chinese manufacturers ran down inventories of raw materials, a signal of softening demand. With China now the focal point for global manufacturing, this had a knock-on effect for the world trade in goods; global shipping volumes most likely collapsed for this reason during the second half of 2018 (see Figure 3) and have since partly recovered. The likely cause of this slowdown was the earlier attempts by the Chinese government and the People’s Bank of China to tighten financial conditions in response to concerns over high levels of debt in state-owned enterprises and local governments. They had also sought to clamp down on a shadow banking sector that was proving hard to control, yet it was an increasingly important source of finance for private firms.

In China there have been signs that stimulus has come through. The central bank cut reserve requirements for commercial banks by 350 basis points – equivalent to over 5 trillion yuan (or over $700bn) of capacity for new lending – since April 2018 and the effects have been passing through. Whereas in the past the Chinese authorities have preferred stimulus measures that raise investment spending, this time they have focused on domestic measures that raise consumption, including tax cuts amounting to $300bn. Value-added tax (VAT) for transportation and construction sectors will be cut from 10% to 9%, and VAT for manufacturers will fall from 16% to 13%.

The euro area appears to be particularly sensitive to China’s industrial cycle, as Figure 2 illustrates. European producers will therefore welcome the fact that Chinese export orders have been rising in recent weeks, which should boost the demand for European exports of capital goods and semi-finished goods.

The Eurozone consumer economy nevertheless remains strong. German retail sales growth has averaged 3.5% per annum since 2015; and for the euro area as a whole, the figure is 2.5% per annum. By Eurozone standards, unemployment across the region is relatively low. Wage growth has been rising modestly towards 2.5% per annum. At the same time, headline inflation has come down to closer to 1.5% on the back of lower oil prices. It is no surprise, therefore, that in Europe there is a divergence between the services PMIs and the manufacturing PMIs, although the hard industrial data in Germany has not matched the gloomy mood of factory managers (Figure 4). Domestic activity and consumption, on the back of rising wages, have driven a moderate turnaround in Europe. More favourable global tailwinds resulting from Chinese stimulus could boost the external sector and raise European growth in the coming months.

Q1 US GDP figures came in strongly at 3.2% (annualized), but they obscured signs of underlying weakness. Contributions to GDP from consumption and non-residential investment declined markedly last quarter, with a collapse in imports and a rise in inventories artificially raising the GDP figure. Forecasts for Q2 GDP growth issued by the Federal Reserve Bank of Atlanta indicate a slowdown to around 1-2% annualised growth – see Figure 5. This is largely on the back of weakening manufacturing sentiment and softer retail trade and auto sales reflecting stricter financing conditions for buyers.

Core US inflation has fallen from its 2% target. We think lower inflation has been largely imported through the low producer price inflation in China that has passed through to US imports. This could, however, be reversed as firms pass on the effect of US tariffs on Chinese imports onto consumers and there are signs that this is already happening.  If overall inflation remains low, that would give cover to the Fed to maintain its dovish stance, lowering the chance that it delivers a surprise interest rate hike during the year. Financial market participants have now priced in 80% probability of a rate cut by the end of the year, and it will prove hard for Fed Chair Jay Powell to reign in these expectations without causing trauma in the markets. 

There are signs of a stabilising world economy. Stimulus in China is coming through; Europe’s domestic economy is holding up while the slowdown in the US could simply be a reversion to a sustainable trend after a year of stellar performance. Nevertheless, the risks are still there.  Corporate debt is high and rising in the US, Europe and China. Collateralised loan obligations continue to be popular. US equity markets appear to have reversed out of late-cycle behaviour in the perhaps misguided belief that the Federal Reserve will keep credit cheap. Then there is the unresolved trade standoff between the US and China. There are plenty of reasons not to be complacent with this favourable turn in global economic events.

By Economic Strategist, Hottinger Investment Management

In 431 BC, Athenian historian Thucydides wrote in his History of the Peloponnesian War that: “It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable.” Modern history too is replete with examples of a rising world power challenging a ruling power in a way that forces the two powers into war.

In 1519, the election of King Charles of Spain as Holy Roman Emperor pushed the then preeminent France into 40 years of conflict in the Habsburg-Valois Wars. In the 17^th century, the rise of England as a global naval power with a foothold in North America set off twenty years of Anglo-Dutch wars. The wars of the 20^th century were at their heart about land, naval and ideological supremacy as Germany and Japan challenged the existing order. Yet war is not inevitable, as the decades-long stand-off between the US and the Soviet Union eventually proved.  

With the rise of China to global superpower status, the United States must contend with Thucydides’s trap and it is hard not to see the events of last week in this context.

Last week, the US government announced that the tariff rate on roughly $200bn of Chinese imports will rise from 10% to 25%. The Trump administration will also begin preparing for 25% tariffs on a further $325bn of imports that – together with the $200bn – make up almost all exports that China sends to the United States. Although China responded yesterday with tariffs of its own, it is still possible that the two sides could agree a trade deal that unwinds these measures.

However, it is clear that the Chinese side has significantly underestimated the force of conviction in the United States for measures of some sort to curb China’s ascendancy as an economic superpower. Support for being tough on China is cross-party. Senior US Democratic Senator Chuck Schumer took to Twitter to encourage the President to “hang tough… and don’t back down” during the negotiations.

Over the last 18 months, the American state has come to a realisation that the terms on which China joined the World Trade Organisation in 2001 are unfair; they have permitted China to provide huge state subsidies to its own firms and to discriminate against foreign firms operating in its territory. The naïve hope in the early 2000s was that China, by joining the global trading system, would become a liberal democracy yet remain subordinate to the United States. That hasn’t happened.

Instead, what has happened is that China has grown to become the world’s largest economy measured by purchasing parity, harbouring grand ambitions – through its Made in China 2025 strategy and its Belt and Road Inititaive – to dominate the Eurasian continent. The current standoff between the US and Iran over its nuclear policies has a Chinese element too, with investment in Iran planned as China’s land bridge between Europe and Asia.

The original impetus for the stand-off, however, was domestic in origin and about the US trade deficit with China.  A trade deficit is not necessarily bad for a country; it is often the flip-side of net flows of foreign investment, a vote of confidence in the strength of that country’s economy. For a country like the United States, which issues the world’s dominant reserve currency and offers the world’s safest asset, US Treasuries, there are structural reasons for its persistent trade (or current account) deficits.

Since global capital markets became liberalised after the breakdown of the Bretton Woods system of fixed exchange rates and capital controls in 1973, the US has broadly always run a current account deficit of around 1-4% of GDP (see Figure 1). With international business dominated by dollars and global investors attracted to dynamic US markets, the country enjoys what economists call an ‘exorbitant privilege’, where US borrowers and consumers can access capital on cheaper terms and US households can buy more than they make in a more sustainable manner than other countries.

One could claim that the trade deficit does not matter because it simply represents an excess of national consumption over national production; no one loses out if Americans buy more stuff from China using funds borrowed from China (see Figure 2). In fact, the argument goes, US consumers benefit from cheaper household goods, computers and smartphones.  This line of thought, however, is misleading because it ignores the distributional impact. The growth of Chinese imports of some items, while small in the context of total imports volumes from China, has harmed US producers of the same goods.

According to the US Census Bureau, imports of iron and steel products have doubled from $1.1bn in 2009 to $2.2bn in 2018. Imports of engine parts, such as carburettors, pistons and valves, have more than trebled to $2bn in 2018. Imports of parts for aircraft and trains have increased by a factor of 2-3.  Imports of trucks have grown by a factor of 8 and passenger cars by a factor of 20 (from $66m in 2009 to $1.4bn in 2018).

While these items do not make up a significant portion of total Chinese exports to the US, they matter for US producers who must compete with them. The US manufacturing Rust Belt built its wealth through making things like steel, machine parts and engines. It reflects areas that swung behind Donald Trump in the 2016 presidential election. An influential study by Autor et al in 2017 concludes that the states of Michigan, Wisconsin, and Pennsylvania would have voted Democrat rather than Republican in that election if the growth of Chinese import penetration in their region had been 50 percent lower than what it actually was. This would have resulted in a victory for Clinton over Trump.

While industrial towns and cities are today part of Trumpland, they are working-class and have traditionally been Democratic fiefdoms, many of which chose Barack Obama in 2008 and 2012. The Democratic Party knows that its route back to the White House runs through these places, which is why there is cross-party support on pushing back on America’s growing trade deficit with China.

Higher tariffs will be disruptive to both US and Chinese equity markets. While many multi-national US firms have been rerouting their supply chains away from China in recent years, due more to rising labour costs than the threat of tariffs, the process is far from complete – and may never be. Companies such as Apple Inc. have built their entire business model around China. US consumers will likely treat higher tariffs as a tax if companies pass them on, which could raise inflation and reduce spending at a time when consumer activity already looks to be softening. In an environment where US earnings already look to be weakening, rising import costs coupled with falling demand could add to the squeeze and could signal the end to the equity market rally in 2019.

However, with equity markets near all-time highs, it will still require a big fallout from these new tariffs to spur the Federal Reserve into action. Earlier this month, with markets widely predicting rate cuts over the next 18 months, Fed Chair Jay Powell has tried to row back from his dovish tone earlier in the year. With core US inflation low and falling, any positive inflationary effect of tariffs could – counter-intuitively – make rate cuts less likely.

Meanwhile, the tariffs could do more damage to China. According to the World Bank, exports accounted for just under 20% of China’s GDP in 2017. The US is also China’s largest trading partner, buying 20% of its exports. If US consumers significantly reduce their purchases of Chinese exports, there would be a material impact on the economy. China has only recently managed to staunch the slowdown of the last six months through tax cuts and monetary stimulus and turn around last year’s poor performance in its stock markets. And as we have mentioned before, what is bad for China is now often bad for Europe.

The US-China trade stand-off is not just about the US Rust Belt; it is also about technology and intellectual property. The US administration is aware that it is engaged in a technological arms race with China that is not just about trade, jobs and GDP but also about the projection of global power, defence and security.  The ongoing dispute involving Huawei and their worldwide 5G footprint could be just the start of a US-China cold war centered on technology and global reach.

Conflict is not inevitable. The Treaty of Tordesillas, brokered by Pope Alexander VI, prevented war between Spain and Portugal over the Americas in the 15^th century. The US surpassed the UK as a world power in the 20^th century yet the two remained allies throughout. And war between the US and the Soviet Union in the late 20^th century never materialised. In all three of these cases, both sides calculated that the costs of conflict were too high.

We should have hope that China and the US are so interdependent that more troubling forms of conflict never come to pass. There is still a good chance that the two sides will agree a trade deal. Nevertheless, for now relations between the two superpowers will remain fraught, which will bear on the outlook for risk assets.