Our Opinion: 2018

Politics, interest rates and trade wars

The market correction that started in October has taken on a life of its own and volatility has continued on the back of new events, such as the arrest of the Huawei CFO in Canada and the leadership challenge to Theresa May in the UK.

As unpredictable political events may continue to cause volatility, forecasting returns and markets in 2019 is fraught with danger. However, if we stay focussed on economic fundamentals, there is more upside than downside for 2019.

Which brings us to the UK. Political events are moving fast, but there is one basic question: when will the UK market become so cheap that all uncertainty is fully priced into it? We are probably now approaching that juncture and many of the Discretionary Fund Managers we work with are seriously considering increasing investment in UK equities, especially if an event can trigger some further drop in relative valuations for the UK versus the rest of the world. We should carefully look at when international investors start returning to the country they have abandoned in droves over the last two years. UK stocks, after all, are paying a higher yield than at any point since the financial crisis.

There are lots of reasons to be nervy about investing in the UK right now. The ever-shifting nature of Brexit is one issue; the potential for a Jeremy Corbyn government and the policies that might accompany it are another not entirely unconnected factor. But there’s an argument to suggest that a lot of this uncertainty is being priced in just now.

The overall dividend yield on the FTSE All-Share index, at around 4.5%, is now floating around its highest level since the financial crisis. FTSE 100 companies currently pay out an average of 58% of income versus the long-term average of 50%. But while there’s no doubt that some stocks are at risk of cuts (phone group Dixons Carphone just cut its dividend by 40%, for example), it’s hard not to be tempted at this level, particularly as high, or at least decent, yields are not limited to any one sector.

Our positive view on markets is also predicated on the outcomes of a couple of crucial issues: the Federal Reserve’s management of rising interest rates and the trade war between the US and China.

The Fed’s monetary policy has markets worried that a recession may be forthcoming if interest rates keep rising, without paying attention to the strength of the US economy or to underlying inflation levels. The Fed has the opportunity, for the first time in its history, to engineer a ‘soft landing’ of the US economy, namely to extend the economic cycle without causing a recession by hiking too much.

And will Trump agree a trade deal with China?

President Trump has the option to get a trade truce signed with China and to remove all tariffs on imports and exports. This would not solve all the contentious issues between both countries (such as intellectual property, hacking, etc) but it would go a long way towards reassuring companies that they can invest in their businesses and keep exporting (or importing) without fear of surprises.

Both of these issues should be resolved satisfactorily for the markets, with a decent pause in Fed hikes and a proper cease-fire between Trump and the Chinese ahead of the 2020 presidential election. However, there is obviously some riskthat it may not turn out that way, with the inevitable market volatility that would accompany it.

The one investment area most dependent on the outcome of these issues is emerging markets. Upon favourable Fed and US-China outcomes, they could soar, having underperformed the world this year. Conversely, their downside could still be significant if both events turned out wrong.

One additional concern for markets is the slowdown in the US and Chinese economies. Whereas both should be quite orderly and some form of fiscal stimulus could be applied, it is unclear how far the slowdown could go. There has been frontloading of export orders both in the US and China to get ahead of potential trade tariffs, and we are now starting to see some stockpiling in the UK ahead of a possible hard Brexit. Although future corporate earnings should still deliver attractive growth, markets may fret at the sight of much lower GDP figures in early 2019.

In a nutshell, headlines should not deter us from finding attractive markets worldwide. Politics may continue to cause further volatility in the New Year but we should remain focused on the economic fundamentals.

18th December 2018