Market View

As I write, Britain is applying for a second Brexit extension with little idea of its ultimate destination, the American-Chinese trade talks are unresolved and we have seen a run of largely disappointing economic data from China and Europe.

The response from financial markets? Well, they have just delivered one of the best first quarters for equities in a decade alongside strong returns from government bonds, credit, high-yield, oil, commodities and most alternative assets¹. In fact, of the thirty stock markets tracked by the Economist only one, Malaysia, delivered a negative return while more than half rose by more than ten percent. To compound this counterintuitive rally, G10’s best performing currency this year was, yes, sterling…

Central banks, bonds and climbing a wall of worry…

What is going on? Three factors probably lie behind the dichotomy. First, financial markets are adept at climbing ‘walls of worry’; having already discounted a protracted US-China trade dispute, an American government shutdown and a slow-motion Brexit last year, the outcome today is at least no worse. Second, the combination of poor economics and worsening geopolitics was the trigger for the most extraordinary volte-face by the Federal Reserve – in a matter of months the members of the central bank’s rate setting committee went from projecting three interest rate rises in 2019 and two in 2020, to none in 2019 and one in 2020².

The U-turn extended to the shrinking of their massive balance sheet which they described as on ‘autopilot’ to one that is now likely see any contraction largely fall away by September. Similarly, the European Central Bank (which seemed to have some urgency to tighten policy and begin the journey from negative rates) has now delayed any increase until at least 2020 and promises more ‘special’ bank support in the meanwhile. In short, central banks have been unexpectedly generous in 2019.

Finally, inflation has been quiescent globally despite rising real wage growth and yet further falls in unemployment. In the UK for example, even though sterling has declined 8% against the dollar over the past year and unemployment is now at a 1971 low of 3.9%, consumer price inflation has fallen back to just 1.9%. This UK phenomenon (and it’s a small and much needed bit of Brexit good news) is occurring globally, with prices below expectations in almost every major economy.

This has contributed to an extraordinary rally in world bond markets - US 10 year yields are down twenty basis points this year while French and German equivalents have fallen nearly thirty (the latter moved into negative territory last month and briefly falling below Japanese yields). Against this backdrop, global equities cannot but look attractive with the yield on local indices relative to their corresponding government bonds is close to all-time highs. France’s CAC 40 equity index for example yields an extraordinary ten times that of the 10-year French Government bond (and its bank stocks nearly twenty…).

Politics versus economics – who wins?

So what are investors to make of these conflicting forces? Yes, the global economy has disappointed, with the IMF cutting its forecast for global growth to 3.5% in January and likely do so again this month. Citigroup’s global Economic Surprise Index, which measures how often data comes in better or worse than forecasts, has been in negative territory for almost a year (its longest sub-zero stretch since 2008). However, this is still far from recessionary territory and warnings from the very brief inversion of the US treasury curve are most likely false alarms (note last week’s solid but not spectacular US labor report). For the Federal Reserve though, this corroborates their stance – yes, growth continues but there is still little risk of accelerating inflation.

A rising populist vote will ultimately influence financial markets…

So if the economic conditions are weaker but at little risk of recession, how will the political trends impact markets? Ignoring for a moment the day to day noise of failed Brexit ‘initiatives’ or Presidential tweets, there are three core trends that concern us:

• First, Brexit Britain is already entering legal and regularity limbo with no immediate exit. Yes, the deal from Europe is needlessly difficult (for any government to sign) but the tribal blocks of British politicians have not yet heeded the ‘national interest’ and found a middle way. The longer this takes the more investment and business sentiment will suffer, and more oxygen is given to populist solutions on the far right and left of British politics. To date, political failure has not meant economic failure but risks are now rising of permanent economic scarring
• Europe’s re-emergence as the weak spot of the global economy (yet again) is foremost a failure of politics. Every commentator knows that much looser fiscal budgets are needed (especially in Italy), German tax cuts should be greater and government spending (even defence) should be higher. The eurozone is still crying out for a common bank deposit scheme and some form of commonly issued ‘euro’ bond. The ‘too little too late’ response to all these issues continues to act as fuel for radical populist solutions
• Finally, in much of the rest of the world we see the continued rise of the ‘strongman.’ In Turkey, Russia, the Philippines, Brazil and many others, leaders are modelling themselves to an extent on the image of President Trump. Yes, this may help ‘get things done’ but multi-year assaults on state institutions, facing unremitting criticism, are the losers. The most worrying example for global investors is the relentless critique of the Federal Reserve Policy in recent Presidential tweets and now the risk of politically motivated appointments

There is a pattern to all of this - namely the much discussed rise in populist rulers whether in democracies or in non-democratic regimes. Bloomberg Economics have attempted to quantify this in conjunction with Freedom House and the IMF. On their albeit widely drafted definition³, 68% of G-20 GDP is now under the governance of either populist rulers in democracies or non-democratic regime - that is a rise from just 33% in 2016. This wave is changing not just politics but policy, and this has implications for investment markets:

• Central bankers may be reluctant to ease further, but with little inflationary pressure and rising political pressure, they have few incentives to tighten – this ‘pause’ is supportive of real asset prices
• G20 governments will increasingly follow the US and embrace looser fiscal policy to respond to populist pressures. In the longer term, this means higher bond yields and ultimately higher inflation. Investors will likely be safer holding inflation proofed equities than very low yielding bonds - robust and progressive dividends payers are a particularly attractive alternative
• Populist governments will target higher domestic growth and stronger real income growth (already evident in US and UK real wages). Companies exposed to consumer demand and particularly new or online models of consumption will benefit. Correspondingly, labour costs will rise, accelerating the demands for automation across all industry groups
• Against a populist backdrop, climate change is one area where there is increasingly a global consensus on action and support for the vast investment needed to change our global energy infrastructure. This remains a key area of future growth for investors as prudent equity risk control

What does this mean for asset allocation? With weaker economic growth but little risk of recession, there is still room for company profits to grow and with inflation quiescent, few reasons for central banks to spoil the party. This is supportive of real assets. Meanwhile as politicians move to satisfy populist demand by lifting real wages and boosting spending, global bond yields should, over time, start to climb. Both views argue for a modest increase in global equities tilted, where appropriate, toward progressive dividend payers. Among equities, our focus will be on the leaders in automation and digitalisation and those embracing new consumer distribution models, while an emphasis on the beneficiaries of climate change is not just good governance but captures the growth of a truly global and ‘populist’ theme.

¹ Sarasin & Partners

² Market Consensus/Bloomberg

³ Bloomberg Economics defines populist rulers as those ‘promising to defend the people against corrupt elites, offering common sense solutions versus complex policies, and advocating national unity over cosmopolitan inclusion or international engagement.’ Based on that definition, it puts Brazil, India, Italy, Mexico, Turkey and the US in that camp.