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“If you are the smartest person in the room, then you are in the wrong room.”

Summary

I can understand why the Brexiteers are opposed to the UK’s Chequers proposal, but I do not understand the European Union’s opposition to it. The Chequers deal would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations, if the UK were not seen as having control of domestic rules or laws or being a credible negotiating partner. In my opinion, the EU, in pushing the envelope and rejecting the deal, has miscalculated. The Chequers deal is better for the EU than a “no-deal” or any other deal frankly. UK Prime Minister Teresa May will now do well to turn this rejection of her proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. Despite the antics and acrimony, I do see the UK and the EU concluding a deal, and it will likely be before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on Word Trade Organisation guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU.

Chequers chucked, so what next?

That there was no deal on the UK’s Chequers proposal at the European Union (EU) Summit in Salzburg last week, shouldn’t have come as a surprise to anyone. The half in/half out deal that this proposal called for, was opposed both within the UK and in Brussels – with only Prime Minister Theresa May pushing for it. The Chequers proposal would provide the UK access to the EU “single market” on goods after Brexit, while services would be governed under different rules. In return, the UK would accept the EU’s “common rulebook” – standards governing manufactured and agricultural products.

Leading Brexiteer Boris Johnson described this proposal as a “suicide vest” for the British constitution. The European Research Group (ERG), a grouping of Tory Eurosceptic Members of Parliament (MPs), who number close to 80, had warned that they would vote against the Chequers plan in Parliament. Brexiteers were opposed to the Chequers proposal as it would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations if the UK were not seen as having control of domestic rules and laws or being a credible negotiating partner. Michel Barnier, the Chief EU negotiator on Brexit was opposed to the Chequers proposal too. Barnier remarked “les propositions sonts mortes (the proposals are dead).”

I can understand why the Brexiteers are opposed to the Chequers proposal, but I do not understand the EU’s opposition to it. In my opinion, the EU, in pushing the envelope, has miscalculated. The Chequers deal is better for the EU than a ”no-deal” or any other deal frankly. The Chequers deal would have essentially kept the UK in the single market for goods (where the EU has a trade surplus of +£100 billion with the UK) and would have kept the UK out of the single market for services (where the EU has a deficit of -£28 billion). The EU would thus continue to sell goods and keep its huge surplus in goods intact. But the EU doesn’t do economics, it does ideology. Ideologically, Brussels saw the Chequers proposal as breaking up the “single market.” In their opinion, enjoying the benefits of the single market (albeit only in goods) without free movement of people would make Brexit look easy. Brussels worried that more copycat departures could follow and the EU would eventually collapse. I disagree with this thinking entirely.

“In my opinion, the EU, in pushing the envelope have miscalculated. The Chequers deal is better for the EU than a no-deal or any other deal.”

‎Just because the UK is leaving the EU and can make a success of it, it doesn’t mean that others will follow suit. If leaving and making a success of it were so easy then Greece and Italy would have left the EU long ago, reclaimed their currencies back and embarked on efforts to reduce crippling debt and rebuilt their economies. It has taken the UK over a decade to organise an “in-out” referendum since it was first mentioned in 2007. It will take a good few years for the UK to chart a path independent of the EU despite the UK having an independent monetary policy and several opt-outs in its current EU membership. Leaving is one thing and making a success of it is quite another. Out of the twenty-eight EU nations, eighteen are net recipients of EU funds, so they are not going to leave the “free money” anytime soon. Of the ten who are the net contributors Germany, the UK, France and Italy contribute the most, and are candidates to leave in a theoretical discussion. However, Germany is the biggest beneficiary of EU project so it won’t leave (until the cost of keeping the EU together outweighs its benefits). France punches above its weight and the EU helps it do it, so they wouldn’t leave either. Italy with over €2.3 trillion of debt and moribund GDP growth has much to ponder before they can consider leaving the EU and the Euro.

The divide between the EU and the UK is one of history and beliefs. It’s about Catholicism vs. Protestantism as political scientists Brent Nelsen and James Guth describe in their book, “Religion and the Struggle for European Union.” Broadly speaking they suggest, Catholics favour the EU more than Protestants. These attitudes were forged in the Reformation that took place in 16th Century Europe. It led to the development of two different approaches to governance in Europe. Catholics see Europe as a single cultural whole that ought to be governed in some coordinated way. Protestants, on the other hand, see the nation state as a bulwark against Catholic hegemony and a guarantor of individual liberty. On the Continent, people are used to the State/supranational bodies running the country. Brussels taking over ”governing” in the 20th Century is no different than Imperial France or the Austro-Hungarian Empire that ran Europe in the 18th and the 19th Centuries. It’s a continuation of history. If you suggest this to Europeans, they may not see it this way. They will tell you that Europe has come far, but the reality is they haven’t come that far and history is not on their side. Their acceptance of the EU is far deeper and not based on reason but a habit. A habit formed over many centuries.

So where do we go from here?

PM May will now do well to turn this rejection of her Chequers proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. It’s time to move on to a “Canada +” deal. At its most basic, a Canada-style deal, is the UK striking a free trade deal with the EU after Brexit along the lines of the agreement the EU recently signed with Canada. This would remove most, if not all, customs tariffs on goods sold between the EU and the UK and potentially allow some market access for services.

So, will the EU accept it readily? Not really. In the EU’s infinite wisdom, this solution would not solve the problem of the Irish border. Brussels fears that Ireland could become a backdoor into the EU market for goods from around the world that may not comply with EU’s standards and tariffs. So, for a Canada-style deal to happen, the UK would have to give assurances on regulations and standards the EU holds dear. If the EU is not assured, it would effectively put a customs and regulatory border in the Irish Sea, something that is unacceptable to PM May. The backers of a Canada-style deal reject the EU’s reservations about it and have long maintained that with the use of technology it would be possible to ensure that goods crossing between Northern Ireland and the Republic fulfil customs requirements without the need for physical infrastructure at the border. The EU physically checks only around 3% of imports, the rest is done electronically and with mutual recognition of standards. So, it is not a big problem to do the same with the Northern Ireland- Republic of Ireland border.

“An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching”

As I have said in the past, despite the antics and acrimony, I do see the UK and the EU concluding a deal most likely before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on WTO guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their close history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU. It remains an issue of mutual recognition of standards. Besides Brexit is not merely a matter of economics. The UK may be leaving the EU, but it is not leaving the US-led Western alliance. The UK’s role is key to sustaining US support for Europe and the guardian of peace in Europe – the North Atlantic Treaty Organisation (NATO) that US President Donald Trump has threatened to withdraw from. An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching. This is well understood in Brussels.

As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. An EU which hasn’t bothered to get its treaty ratified by member states (because it can’t be sure of the outcome) and ignored the result of previous referendums in member states, is galaxies away from a Europe a la carte. Those seeking a second referendum are wasting their and everyone’s valuable time. They are well advised to offer their time, money and services to charitable work. ‎

Markets & Economy

As expected the US Federal Reserve (Fed) raised interest rates by +0.25% Wednesday, as it continues to gradually roll back its policies of easy-money. This lifts the Federal-Funds Rate to between +2% and +2.25%. The increase, is the third this year and the eighth since the Fed began to raise rates in late 2015. For the first time since 2008 the benchmark rate is above 2% and also above inflation, measured by the Fed’s preferred gauge, Personal Consumption Expenditures (PCE) which excludes the volatile energy and food categories. The so-called core PCE index rose +2% in July. Fed Chairman Jerome Powell remarked, “This gradual return to normal is helping to sustain this strong economy for the longer-run benefit of all Americans.” Trump, in a press conference later said he was “not happy” about the Fed raising rates. He however added, “They are raising them because we are doing so well” and that higher rates weren’t all bad because they could help Americans who rely on interest savings for income.

Between this rate increase and the Trump tax increase, I mean the Trump tariffs, the US economy risks slowing down. How soon that happens will depend on the level of tariffs implemented and how quickly the Fed continues to raise rates. The Fed hinted it will raise rates one more time this year and by one percentage point through next year. If Trump raises tariffs to 25% and they stay there, and the Fed Funds Rate goes up to 3% or more, then recession fears will increase. For now, I have no such fears.

While the China-US trade war has dominated the narrative over the last quarter, rising oil prices are now getting everyone talking. Impending sanctions on Iran have lifted crude prices. Trump has called for the Organization of the Petroleum Exporting Countries (OPEC) to increase the oil supply and stop “ripping off the rest of the world” by pushing oil prices higher. However, at its meeting in Algiers on Sunday, OPEC and Russia reiterated that they want to adhere to current production quotas first implemented at the start of 2017. If the glut of oversupply goes, demand continues to increase and US oil inventories fall – then US sanctions on Iran and a Trump defiant OPEC spell higher oil prices. Brent could easily get to $90 and over in the short term.

Source: Bloomberg

Regular readers of this newsletter will know that I have been bullish on US equities and overweight US equities for a long time now and even during all of this year, despite the market talk of recession and an impending market correction. The S&P 500 index (SPX) has not disappointed and continues to pass the “back to school” test as we enter autumn after a volatile summer. The SPX broke out to a new high (chart above) at the end of August and pulled back in early September. Crucially the pullback found support right at its prior highs from January. After holding that level, the SPX has continued to trade higher. If you are a chartist, it doesn’t get much more textbook than this. With the US economy growing at over +3.5%, no signs of a recession on the horizon and a measured escalation of the US-China trade war, the SPX has legs to continue reaching new highs. Besides, many investors and commentators are still sceptical about the SPX rally and that’s a good thing. You should worry when everyone is bullish.

While the SPX index has recovered nicely from a pullback early this month and is up +9% Year-To-Date (YTD), Europe’s flagship Euro Stoxx 50 (SX5E) Index has slipped down further, -2.3% YTD, and so has the MSCI Emerging Market Index, -10% YTD (table below). The SX5E could have been worse off had we not seen a rally in European stock (particularly financials) on the back of reducing confrontation between Italy and the EU over the Italian budget. The Italian government officials from both parties – 5 Star Movement and the League – have pledged to respect EU rules limiting deficits, after a squabble to break EU rules on fiscal discipline led to heavy selloffs of Italian bonds over the summer.

The prospect of a quick resolution to the US-China trade war has dimmed. Trade tensions between the US and China will be a drawn-out affair as this is more than a trade spat. It’s about global influence and leadership. Jack Ma, Alibaba’s Executive Chairman rightly remarked – “It’s going to last long, it’s going to be a mess. Maybe 20 years.” Early this week China cancelled trade talks set for this month and the US imposed 10% tariffs on $200 billion of Chinese exports to the US. China responded with tariffs on $60 billion of US exports to China. This is likely to beget US tariffs on the remaining $267 billion of Chinese exports to the US i.e. just about all imports from China would face a tariff going forward.

The war of words will continue and as Winston Churchill and Harold Macmillan used to say “Better jaw-jaw than war-war.” I think the world and markets can endure a war of words, however long this takes. The US is the declining power and China is the rising power, but there needn’t be a war. The sensible thing for the US to do would be to agree on a deal with China and open China’s market to US products. China is shifting its economy from being the world’s largest exporter to the world’s largest consumer. Speaking at the World Economic Forum (WEF) early this year Chinese President Xi Jinping remarked that over the coming five years, China would import $8 trillion of goods. US companies want in on this. Trump may have his own ideas but he is not an ideologue. You can see that from the exemptions granted to a range of products (particularly Apple’s products) in the latest round of tariffs imposed by the US. US businesses and indeed European businesses are not ready to forfeit this opportunity of China trade – an emerging Chinese middle class of 300 million people with average income growing at almost double digits. The US will have to learn to live with reduced influence as China rises until such time as China has its own political troubles. The US doesn’t have to worry about any other power eclipsing it. A declining and bureaucratic Europe will never be much of a challenge to the US and Russia may be a military power but it will never be an economic power given the paranoia and mistrust that grip the nation and its leadership.

Having said that, the EU’s announcement this Tuesday that it would establish a special payments channel to maintain economic ties with Iran is significant and it may be a first step to challenging the supremacy of the US Dollar. Should America be worried? Not so fast. Can American counter the threat? Absolutely. You can do business with Iran or you can do business with the US, but not both. The risk of losing access to the $20 trillion US economy and being cut off from the Western financial system can sober any business and the next time the ECB comes to the US Federal Reserve window to arrange Dollar swap lines, you can be sure what the response will be. European banks will be foolish to provide payment options to companies seeking to do business with Iran. It will be like picking up pennies in front of the steamroller. The US Dollar will meet its challenge but this is not the moment.
After having a bad first half of the year, Q3 has been extremely good for the Healthcare, Industrials and Financial sector stocks. As the table below indicates, almost all of the year-to-date performance for Healthcare stocks has come in Q3. This good performance is set to continue. Healthcare stocks are seen as safety stocks and as the rally gets old, defensive sectors – Healthcare, Consumer Staples, and Utilities will see increased inflows. Again, as I have said above, I do not see a US recession on the horizon and an inflation surprise to the upside also looks distant.

I continue to be overweight US stocks with sector preferences for Technology (XLK), Financials (XLF), Healthcare (XLV) and Industrials (XLI). I remain underweight Europe and underweight Emerging Markets.

In terms of stocks I like : VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“’If you tell the truth, you don’t have to remember anything.”

Summary

China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels, US President Donald Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. Patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to. The US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. A second wave of direct payments to farmers is likely to follow if tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price. As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, Americans will be faced with the question – at what price patriotism?

At what price patriotism?

This week we learnt that the US will pay its farmers $4.7 billion to offset losses from the tariffs imposed by China on agricultural imports from the US. Furthermore, the US Department of Agriculture (USDA) could decide by December to make a second wave of direct payments to farmers if damages from trade tariffs persist. The farmers “cannot pay their bills with patriotism” and patriotism has its price.

Last year, Michael Anson, who works in the Bank of England’s (BoE) archive along with Norma Cohen, Alastair Owens and Daniel Todman from Queen Mary University of London, made a startling discovery – the spectacular failure of UK’s first bond issue of the Great War in 1914 and the extraordinary role of the Bank of England (BoE) in the cover-up that followed.

In the early days of World War I, the British government sought to raise £350 million (about £38 billion in today’s money) through the issuance of “war loans.” Britain’s banks agreed to subscribe for £60 million and the BoE agreed to take £39.4 million on its books. The remaining £250 million was expected to be sold to the public by appealing to their patriotism. The issuance went ahead and the bond sale was heralded as a great success. The Financial Times reported on 23 November 1914 (clip below) that the Loan had been over-subscribed. It gushed – “by motives of patriotism no less than by thought of securing a good investment, the British Public has offered the government every penny it asked for – and more ….and still the applications are pouring in!”

Source: The Financial Times, 23 November 1914

The reality, however, couldn’t be more different. The public demand for “War Loans” was woefully low and amounted to a grand total of £91 million i.e. one-fourth of the amount the government wanted to raise from the public by appealing to their patriotism. At the time, if this failure had become public knowledge, it would’ve crashed the price of existing UK sovereign bonds and endangered any future capital raising by the British government thus undermining its preparedness for what was to follow in the Great War. The BoE officials, therefore, hatched a plan to cover up the shortfall. The BoE’s then Chief Cashier Gordon Nairn, and his deputy, Ernest Harvey, bought the securities in their own names using the bank’s money and the bond holdings were classified as “Other Securities” on the bank’s balance sheet rather than as holdings of government securities. The British Government of the day led Prime Minister Herbert Henry Asquith and his Chancellor David Lloyd George then declared the bond issuance a success and hailed it as a sign of patriotic fervour among the British people. And you thought “Fake news” was something new?

In a secret memo to the then Treasury Secretary John Bradbury, economist John Maynard Keynes called the effort of the BoE to step in and buy the unsubscribed bonds for its own account as a “masterful manipulation.” Today, we, of course, call it Quantitative Easing (QE) and we don’t make any effort to hide the “manipulation.”

Additionally, the funds that were raised from the public came from a very small group of financiers, private individuals and shipping companies that were among businesses benefitting from surging war demand for their services. Half of all investments were for £200 or less i.e. most of the wealthy British would rather have put their country in peril than part with their money. Patriotism was not enough.

Every patriotism has its price and particularly in free, capitalist and profit-seeking economies such as the US and the UK where governments cannot coerce capital to act against their interest. Capitalists have no nationality or national interest and they tend to gravitate towards opportunities that offer the best risk-adjusted return. Unless of course you are a capitalist in Russia or China and then you do what the government tells you to.

I continue to believe that there won’t be a full-fledged trade war between the US and China as it is not in either one’s self-interest. Over the weekend we learnt that US President Donald Trump had reached a “trade deal” with Mexico. As we know, the talks between the US and Mexico appeared close to collapse many times during the past 12 months. China and the US are talking again and that’s a good thing. With 2Q’18 US GDP growth of +4.2% and historically low unemployment levels in the US, Trump must know he has a window to renegotiate a trade deal with China from a position of strength. However, he mustn’t forget that the window will not remain open forever. The strong GDP growth in 2Q is attributable to a pick-up in trade activity in advance of the implementation of tariffs and increased consumption on the heels of the recent tax cut. Tax cuts are one-time adrenaline shots. A shot that Trump cannot administer or afford at will. GDP growth is forecast to ease to +2.9% in the 3Q and +2.6% in the 4Q of this year. Quarterly growth is expected to average just +2.2% in 2019. Besides, China is rapidly diversifying its economy and its reliance on the US. A rising debt and a trillion-dollar deficit that the US faces can easily be exacerbated with tariffs and the window of opportunity could close sooner than Trump expects.

As Trump ratchets up the number of Chinese exports that he is willing to levy a tariff on, the Americans like the Brits in 1914 will be faced with a question – at what price patriotism?

Turkey’s crisis is not a systemic risk

The big news in markets recently has been Turkey. The Turkish Lira has depreciated by over -40% this year, the current account deficit has widened to -6% of GDP and inflation runs at over +15%. Whilst it’s easy to draw parallels with the 1997 Asian Thai Bhat crisis and fear for the health of Emerging Markets in general, the only commonality between the two episodes is that it was a period of big capital inflows and then outflows, but the underlying conditions in Emerging Markets today are very different.

Robust economic growth over last two decades, floating exchange rates, high foreign reserves, and greater transparency have reduced the need for abrupt adjustments. Low single-digit current account deficits and in some cases (South Korea, Taiwan, Hong Kong and the Philippines) surpluses, are insulating these economies and the risk of contagion has consequently been reduced. Turkey defaulting on its debt – private or public – is very unlikely to cause a repeat of the Emerging Market crisis we saw in 1997. The problem Turkey faces is of its own making. A sharp increase in credit growth and government spending, financed by short-term capital flows (70% of Turkey’s debt is denominated in US Dollars and Euros) led to a rapid worsening of its current account deficit and left it vulnerable to both the USDTRY exchange rate and outright funding risk. Turkey’s crisis is not a systemic risk.

Turkey, however, does pose a risk to the European economy through its links with European banks and geopolitics. Spain’s second-largest bank Banco Bilbao Vizcaya Argentaria (BBVA) is the most exposed bank in the European Union (EU). BBVA owns 49.9% of Turkey’s Garanti Bank, the second largest private bank in Turkey. Unicredit, Italy’s biggest bank owns around 40% of Yapi Kredi (YKGYO.IS), Turkey’s fourth-largest bank, through a local joint venture. ING, the Dutch bank has a fully-owned subsidiary in the country, ING Turkey. BNP Paribas, the French bank controls 72% of the Economy Bank of Turkey (TEB), partly through a local joint venture. HSBC operates HSBC Turkey in the country. Of these five European names, only BBVA looks at risk of any meaningful capital impairment from the economic situation in Turkey. Garanti accounts for around 13% of BBVA group’s earnings. Of greater concern are the implications on geopolitics. An economic meltdown in Turkey could easily spill over into Europe and cause further unrest in the Middle East thereby triggering a new wave of immigration to Europe. Wary of this risk, Berlin is now considering providing emergency financial assistance to Turkey.

Markets & the Economy

Other than Turkey, it has generally been a positive time in the markets if you were overweight US equities. The S&P 500 index hit a new all-time high and is now above the 2900 level. The US Technology index, NASDAQ is also trading at an all-time high and is up +17.5 this year. Meanwhile Europe’s flagship Euro Stoxx 50 Index is down -1.8% and the MSCI Emerging Market Index is down -7.6%. The chart below details the performance of other key Equity Indices.

The Federal Open Market Committee (FOMC) minutes released for the July/August meeting was very upbeat and signalled more rate hikes this year. Last week, US Federal Reserve Chairman Jerome Powell, speaking at the annual symposium in Jackson Hole, Wyoming defended the Fed’s strategy of gradually raising interest rates even as he was criticised by Trump for moving too quickly. Powell reiterated his view that gradual hikes in rates will be needed as long as the economy remains healthy. “There is good reason to expect that this strong performance will continue” he said. At a fundraising event the week before last, Trump remarked that he was “not happy” about interest rate increases which the he feared would cool off the fast-growing economy. Before Trump, the last President to publicly call for lower interest rates1 was George H.W. Bush during his re-election bid in 1992. Bush later blamed then Fed Chair Alan Greenspan for his election defeat and said – “I think that if the interest rates had been lowered more dramatically that I would have been re-elected President because the [economic] recovery that we were in would have been more visible. I reappointed him [Greenspan], and he disappointed me.” Before that in the 1970s, political pressure on former Fed chairmen William McChesney Martin by the then President Lyndon Johnson and later on Arthur Burns by the then President Nixon (before his 1972 re-election) led to inflation surges as rates were kept low. The Fed later came to view these as a costly mistake. I do not expect the Fed to yield to political pressure and make the same mistake. The Fed has raised rates twice this year, most recently in June to a range between +1.75% and +2%. I expect the FOMC to raise rates by +0.25% when they meet in four weeks’ time.

Last week also saw headlines – “The end of Greece’s marathon bailout.” Only in the EU could a bailout be described as ended by completely ignoring the over €330 billion that has to be repaid by 10 million people who don’t like paying taxes. Euphoria in Brussels and official press releases rushed to claim Greece had exited its multi-year bailout program and it was once again a “normal” country. If only that were true. Taxes and regulatory burdens put on Greece as part of the bailout program have made growth unstainable and economic prospects still remain grim. Besides the Value Added Tax (VAT), small business tax rates, fresh pension cuts and new punitive income tax rates for the poorest are all scheduled for 2019. The charade of interest payment deferrals and extending the maturity of the debt can only go so far. Give it a few months and Greece will be back in the news seeking a fresh bailout. Greece is like Groundhog Day but without the happy ending.

The European Central Bank (ECB) has said it expects to phase out its bond-purchase programme by the end of the year, although it has also signalled that its policy rates, which include a negative deposit rate, would stay where they are at least through next summer i.e. the gulf between the ECB and the Fed policy rate will only get wider. The Eurozone still needs stimulus whereas the Fed plans to press ahead with raising rates. I am not bullish on the Eurozone growth and don’t see how the ECB will be able to end its QE policy this year in face of a growth slowdown and the fear of Trump tariffs hanging like the sword of Damocles over the head of the EU.

I continue to remain Underweight Europe and overweight US equities with a bias to Technology (XLK), Healthcare (XLV), Consumer Discretionary (XLY) and Financials (XLF). However, in Europe, few stock-specific trades are still worth holding or adding to. Luxury stocks like Louis Vuitton Moët Hennessy (LVMH) and infrastructure and industrial stocks (Vinci, Eiffage, Siemens, Bouygues) offer a good investment opportunity for completely different reasons. The world’s well-heeled shoppers are doing just fine and are unruffled by trade fears as they continue to splurge on handbags, jewellery and fine wines. Revenue at LVMH in the first half of this year hit €21.8 billion, up 10% compared with the same period a year ago and net profit jumped 41% to €3 billion. The case for industrial stocks is boosted by the urgent need for Europe to upgrade its infrastructure in the light of the catastrophic bridge collapse in Genoa. French President Emmanuel Macron is under pressure to step up spending on infrastructure after a government report warned that approximately 840 road bridges in France are in danger of collapse.

I was on Bloomberg TV last week for an hour discussing my views on Brexit, the US economy, European Banks and the crisis in Turkey. You can watch it at this Bloomberg Surveillance link (skip to 57 min).

In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

1 Greenhouse, S. (1992, June 24). BUSH CALLS ON FED FOR ANOTHER DROP IN INTEREST. The New York Times. Retrieved from https://www.nytimes.com/1992/06/24/business/bush-calls-on-fed-for-another-drop-in-interest.html

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“To be ignorant of what occurred before you were born is to remain always a child.”

Summary

Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. The US became the dominant economic power in the early 20th Century by having high protective tariffs and this served as a model for later day mercantilists – Germany, other European nations and most recently, China. George Washington, the first President of the United States, not only supported the protection of infant US industries, but also set an example by “buying American.” The US Presidents that followed Washington carried on the protectionist policies as they built America in the 19th Century. The Republican Party dominated the US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. History is a great thing. One just has to look back far enough to cure one of all prejudices.

American Protectionism

Let’s face it, there is no such thing as “free trade”, only good or bad trade deals. The debate about “free trade” and capitalism can be neatly divided into two distinct camps – Liberalism and Mercantilism. Liberals see the State as predatory and Business as profiteers and the two shouldn’t be allowed to work together to the detriment of the individual consumer. Liberalism places the individual’s interest at the heart of economic policy-making, with the objective of increasing household consumption i.e. giving the individual consumer easy and unhindered access to the cheapest possible goods and services. Mercantilists, on the other hand, don’t see this separation between the State and Business as a necessary condition to benefit the individual consumer. They see the two as allies and emphasise that the aim of economic policy-making is to improve the productive capacity of the nation in pursuit of economic growth, power and independence. For the Mercantilist, a sound economy requires a sound production structure within the nation and not a cheap production structure abroad. Mercantilists believe that a robust domestic consumption can only be underpinned by high employment at appropriate wages and not cheap goods from abroad. What does the Liberal like to call the Mercantilist? A Protectionist. Although China may be the most recent example of mercantilism/protectionism, if one were to look at the timeline going back to the 18th Century, it is the US that is the most protectionist nation. It became the dominant economic power in the early 20th Century by having high protective tariffs and it served as a model for later day mercantilists – Germany, other European nations and most recently, China.

I often get a strange look from my friends and colleagues when I make the observation that America was a “protectionist” nation. Perhaps you are frowning at me now as well. However, please indulge me and keep reading.

From the time of its Independence, through the Civil War in the 19th Century and the Great Depression in the 20th Century, the United States of America followed a “protectionist” policy as it looked to get the better of Great Britain and establish itself as the dominant economy in the world. George Washington, the first President of the United States from 1789-1797, not only supported the protection of infant US industries but also set an example by “buying American.” He said – “I use no porter [ale] or cheese in my family, but such as is made in America.” Alexander Hamilton, President Washington’s Treasury Secretary and the founder of America’s financial system argued in favour of a national industrial policy that inspired the likes of American economic nationalists Daniel Raymond and the German-American economic thinker Georg Friedrich List. Raymond believed that the “protective tariff represented national interests and that it allowed for the nation’s people a leverage, and special treatment granted to them over foreigners” in the fields of domestic commerce and industry of the nation. List, whose vision of a united Germany with a protected market was realized later in the 19th Century, believed that “the cost of a tariff should be seen as an investment in a nation’s future productivity.”

The US Presidents that followed Washington carried on the protectionist policies, as they built America in the 19th Century. The Republican Party (led by men such as Lincoln, McKinley, Roosevelt, Harding, Coolidge and Hoover) dominated US politics from the Civil War (1861-65) to the Great Depression (1929-39) and were overtly protectionist. The US Economist Joseph Schumpeter called tariffs the “household remedy” of the Republican Party. It wouldn’t be too off base if instead of calling the GOP – the Grand Old Party, one called them – the Grand Old Protectionists. Tariffs were used both to generate revenues as well as to protect the American economy from British and European imports. President Franklin Roosevelt summed it up well when he declared, “Thank God I am not a free-trader. In this country, pernicious indulgence in the doctrine of free trade seems inevitably to produce fatty degeneration of the moral fibre.”

America’s commitment to a “free market” is a relatively recent phenomenon. Post 1945, America achieved the status of an unrivalled superpower and found itself in total control of the markets with a ravaged Europe and Japan and an Asia too poor to offer any challenge to its hegemony. With no threat in sight and the vast world economy to sell goods and services to, America discovered a love for a “free market” purely out of self-interest. It ran a trade surplus for over 30 years selling goods and services to Europe, Japan and Asia whilst helping them re-emerge from the devastation of the Second World War. The love for “free trade” didn’t last long, however. The latter half of 1970s and early 80s saw massive capital outflows from the US and migration of manufacturing and this turned the US from a trade surplus to a trade deficit nation. As trade and budget deficits mounted and Japan achieved a rival status, America strong-armed Japan into signing the “Plaza accord” in a move to shrink the US trade and budget deficits. The US had a temporary respite and deficits began to narrow in the 90s until China came along. The accession of China into the World Trade Organisation (WTO) accelerated the US trade deficit as Liberalism (Clinton, Bush, Obama) won and Mercantilism/Protectionism lost. Now, the US is back to protectionism once again and once again under a Republican President, Donald Trump. China is accused of “protectionism” and the US is heralded as a “free trader.” History is a great thing. One just has to look back far enough to cure one of all prejudices. In that, I am reminded of this Marcus Tullius Cicero quote: “To be ignorant of what occurred before you were born is to remain always a child.”

From the US point of view, over three decades of liberalism have eroded its economic might and a return to mercantilism, as Trump proposes, is like a reversion to the mean. However, can this be achieved? Is the US ready to pay the price it will take to return to its mercantilist past? That’s the trillion-dollar question. If tariffs start biting US consumers, Trump’s “Make America Great again” could simply turn into “Make America Grate.”

Markets & the Economy

Things are stirring at the Bank of Japan (BOJ). Under its “yield curve control” (YCC) policy, the BOJ committed to holding 10-year yields at around 0%. This policy has been around since September 2016 and has been successful, thus far, in staving off deflation and keeping the Japanese Yen (JPY) weak. Over the weekend, there were reports that the BOJ was looking to move this target yield higher. That was enough for the market to sell the 10-yr Japanese Government bonds (JGBs) and yields spiked up by 10 basis points, which is a big move in Japan. The yield on 10-year JGBs rarely moves more than one basis point during a day’s trading. The BOJ had to step in to prevent more of a sell-off and it offered to buy unlimited amounts of the bonds at a yield of +0.11%. This had the desired result of preventing any more sell-off in the JGBs and in fact, the Central Bank didn’t wind up having to buy any bonds. The BOJ is trying to steepen the yield curve and help Japanese banks so they can in-turn boost the economy by making more loans. It’s a dangerous game, as the BOJ is nowhere near achieving its +2% inflation target and if the market interprets this as the BOJ being a step closer to unwinding its aggressive monetary stimulus – then the Yen will rally and undo years of BOJ stimulus. The BOJ is holding a two-day board meeting beginning on July 30. I do not expect a change in the YCC target and expect the BOJ to reiterate its faith in this policy.

On July 6, President Trump imposed a 25% tariff on $34 billion of Chinese exports to the US and threatened to impose a 10% tariff on another $200 billion worth of exports, if China retaliated. China shrugged off this threat and last week imposed a 25% tariff on the same value of US products— mainly agricultural products such as soybeans, cotton, beef, pork, dairy, and nuts. This week Trump indicated that he was willing to put tariffs on all $505 billion of goods the US imports from China. You’d think that risk assets would have reacted badly to this tit-for-tat trade spat. Not really. In fact, July has been a great month for risk assets. The S&P 500 index (SPX) is up +3.75% this month and continues the uptrend off the early April lows with a series of higher highs and higher lows (see graph below) as Q2 earnings have come in thick and fast, with the majority of them either meeting expectations or surprising to the upside.

S&P 500 index: Performance 2018 YTD

Of course, the effect of US tariffs on steel and aluminium, which came into effect on June 1, is showing up as well. Alcoa reported its Q2 earnings last week and it indicated that the recently enacted US tariffs on steel and aluminium are hurting its earnings. Only 14% of Alcoa’s global aluminium output is produced in the US. The rest is imported. The stock promptly fell -13% as the market started pricing the hit to Alcoa’s earnings from more expensive imports. General Motors (GM) reported Q2 earnings yesterday and while the net income rose the stock fell -7% on the unexpected high raw-material costs in the wake of US tariffs.

As I mentioned earlier, while imposing tariffs may be Trump’s objective of returning America to its mercantilist past, the success of this policy will depend on the price American consumers are willing to pay. Tariffs on the scale of $505 billion, would inevitably lead to chaos and price rises for everyday products in the US and the retaliation that would follow would hurt the US economy and US businesses. Regular readers of this newsletter will know that I do not believe Trump will sacrifice the US economy and go for an all-out trade assault on China, the US’s biggest and most important single nation trading partner. Wages in America are not rising fast enough and are growing at an annual rate of +2.7%. A tariff of 10% on everyday goods? Trump will have to be careful to not impact US consumers too adversely, if he wants to keep playing Marshall Will Kane in the movie High Noon out to save a town.

Trump’s protectionist bark is likely bigger than his bite, particularly with respect to the US trading relationship with China. The US is on target to run a $1 trillion budget deficit by 2020 and the national debt is heading to over +100% of GDP. The US can ill-afford the extent of deficit spending it would need in case of a full-on trade war with China without adversely and terminally affecting its future prosperity. I, therefore, continue to be overweight US equities, with a preference for Healthcare (XLV), Financials (XLF) and Technology (XLK) stocks.

Despite the “deal” that Trump and Jean-Claude Juncker, President of the European Commission, announced last night, I am wary of European equities. First of all, it’s not a “deal” but a start of a negotiation to get a “tariff-free” deal and to get rid of all “trade barriers and subsidies.” Secondly, there’s no timetable for progress and that is troubling given how long it takes for the European Union (EU) to negotiate even a simple trade deal. Third, have you ever seen a La Poste or a Gendarmerie car which was not a Renault, Citroen or Peugeot? I haven’t in over a decade of my travels to France. Protectionist France doesn’t have a trade imbalance with the US. Why then would President Emmanuel Macron of France agree to remove all “tariffs, barriers and subsidies” and open the French market to competition and pick a fight with the powerful trade unions in France? His closet is already full of troubles and his popularity is sinking like a lead balloon. Finally, to understand Trump’s motivation to slap a tariff on autos you have to understand the US auto market and what it means for Trump and the US rust-belt economies.

The US auto market recorded annual sales of 17 million vehicles in 2017, of which just 4 million were produced in the US. Trump wants the US to stop importing 13 million vehicles each year and force its manufacturers to produce them in America, creating manufacturing jobs in the hollowed out American rust-belt. In that, Trump is taking a lesson from China which imports less than 1.5 million of its annual 28 million auto sales. Therefore, I will believe an EU-US “free trade” deal on autos and other industrial products when I see it. With crucial mid-term elections ahead, Trump only wants cover for his attacks on China that have brought about the tariff on US agriculture exports to China. To alleviate the pain inflicted by that tariffs on US farmers, Trump had to announce a $12 billion subsidy this week. Europe buying soybean and liquefied natural gas (LPG), at least until the mid-term elections, plays into Trump’s hand and he looks magnanimous as US farmers offload their soybeans in Europe. Post mid-term elections, he can beat up on the EU again, as public opinion will be behind Trump riding high on his mid-term success. I see this EU-US truce as temporary, and hostilities will renew post mid-term elections.

Emerging Markets have taken a beating thus far this year as the US Dollar strengthened. The MSCI Emerging Market ETF (EEM US) has underperformed the SPX by more than -10% and is due a catch up as sentiment improves and the USD rally halts. There is also the stimulus from China. At a meeting led by Premier Li Keqiang this week, the State Council, China’s cabinet, vowed to use more proactive fiscal policies to spur growth. I would however not recommend a long position in Chinese equities traded onshore, but instead would recommend the large cap Tech names that trade on US stock exchanges – Alibaba, Baidu, Tencent and JD.com. Semiconductor stocks such as Micron Technology (MU US) are another favourite of mine. China accounted for more than 50% of Micron’s revenue in fiscal 2017. The stock was hit hard due to fears of tariffs but that seems to be easing. The stock still trades at under five times forward earnings estimates and could double over the next 12-18 months.

As for Financials, which have had a bad run this year, the Q2 earnings came in strong with Q2 profits rising +16-20% year-over-year. Yet, bank stocks – JP Morgan, Bank of America and Citi – have not been well bid. This is a mistake. Results showed that demand for loans remains strong. The latest US Federal Reserve data, for the week ending May 2, shows total commerical and industrial loans outstanding up +3.1% from a year earlier, compared with +0.9% at the end of January. This is still lower than the robust growth of +10.6% and +6.5% in 2015 and 2016 respectively, but clearly way better than just+ 0.7% in 2017.

In terms of other stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Pepsi (PEP US), LVMH (MC FP), General Electric (GE US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

Summary

Society is a three-legged stool where each leg – economic, political and social – has to hold for the stool to stay upright. We often spend too much time and too many resources analysing and reporting on the economic and political legs, forgetting that the social leg is just as important, if not more so. Unaddressed, or wrongly addressed, social concerns have a tendency to creep up quietly and overwhelm societies – Brexit, Trump and the populist movement sweeping across Europe are good examples of this. German Chancellor Angela Merkel is finally in political trouble, not for economic mismanagement, but for her immigration policies. How fast the tide turns! When Merkel opened Germany’s borders to thousands of asylum seekers three summers ago, people in the affluent state of Bavaria rushed to help in such great numbers that authorities had to briefly turn back offers of clothing and food. It’s the same Bavaria now that has become Merkel’s Waterloo. The Christian Democrat Union (CDU) and the Christian Social Union (CSU) have formed a common group in the German Bundestag since 1949. However, this 70-year partnership that has provided leadership to the Eurozone over last two decades, is now at a breaking point. For the European Union (EU) and the Eurozone, the only thing worse than a strong Germany is a weak Germany. With the exit of Merkel, the EU would be robbed of the only political leader who appears to have the stature and experience to hold the bloc together, as it stumbles from one crisis to the next.
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“The individual has always had to struggle to keep from being overwhelmed by the tribe. If you try it, you will be lonely often, and sometimes frightened. But no price is too high to pay for the privilege of owning yourself.”

Summary

Italy, the beating heart of the European Union (EU) has gone from being a cheerleader of the Euro to a vociferous opponent. The market has taken note of a potential crisis brewing in Italy as a new populist government takes office. The yields on the Italian sovereign bonds (BTP) are rising and if you are looking to insure against a default, you will have to pay more to protect yourself against default on Italian bonds than Russian government bonds. That’s because, at €2.3 trillion, Italian sovereign debt is 132% of Italy’s GDP. Italy’s problems are lack of growth, shrinking industrial production and the absence of independent monetary policy levers to handle these. Since the peak of the financial crisis in 2008, Italy has lost over 9% of its GDP and a quarter of its industrial production. The average annual rate of growth per head in Italy, since the adoption of the Euro in 1999, has been zero. Therefore, an Italian born in 1999 who just turned 18 and has become eligible to vote for the first time, has seen nothing but economic stagnation during his lifetime. Yet, Italy is no Greece. Italy’s GDP at €1.7 trillion is ten times that of Greece. Italy runs a current account surplus, a healthy savings rate, and is a net contributor to the EU budget. Italy can not only survive outside of the Euro, it can thrive. The European Central Bank is nearing the technical and political limits of Quantitative Easing, and the growth in the Eurozone is slowing down. If yields keep rising and growth doesn’t pick up, it is likely Italy will relapse into an insolvency spiral. If Rome is then asked to submit to austerity for a second time, it will likely take matters into its own hands. The Euro experiment, therefore, may be nearing its end.
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“There are two kinds of forecasters: Those who don’t know, and those who don’t know they don’t know.”

Summary

In the 1930s, for over eight and half years, the US ran a trade surplus. Presumably, had Donald Trump been US President at the time, it would have made him a very happy man. Or maybe not. The 1930s will be remembered for the Great Depression, the worst economic downturn in the history of the industrialized world. President Trump likes to blame “tariff barriers and unfair trade practices” for America’s trade deficit. However, the key issues that are prevalent in the US since the 1980s, are a high domestic consumption rate, a low savings rate and a low investment rate. America has a deficit because it consumes more than it produces and spends more than it earns, both privately and as a nation. The obsession that every country’s policymakers has with running a trade surplus ignores one basic reality: All governments cannot run a trade surplus. For every surplus, there has to be a deficit. For the sake of the US Dollar and the US itself, Trump should focus on the budget deficit and the national debt and not obsess excessively with the trade deficit. If the recent tax cuts fail to accelerate US growth, let alone reach +4% as Trump has suggested, the deficit will soar and make fiscal conditions worse. How long will foreign investors then continue to finance the US deficit? Every indebted economy has a day of reckoning. For the US the risk may not be immediate but it certainly is rising. It was debt that caused the UK and Sterling to lose their crown to the US and the Dollar. The enormous post-war balance of payments deficit was just too much for the UK. Debt had taken its toll.
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“What kind of society isn’t structured on greed? The problem of social organization is how to set up an arrangement under which greed will do the least harm; capitalism is that kind of a system.”

Summary

From haggling over the price of tea on a quayside in Guangzhou in 1784 to trading in electronics and t-shirts today, over the course of more than two centuries, trade between the US and China has grown beyond imagination. This trade relationship is now the most significant in the global economy.

The world’s two largest economies account for 40% of global GDP, a quarter of all exported goods, and 30% of the world’s Foreign Direct Investment (FDI) outflows and inflows. Their fates are inextricably linked. In a way, they complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete with the US when it comes to product design or research and development capabilities.

The world’s most cost-competitive and largest electronics industry supply chain is in Shenzhen, China. China’s manufacturing capacity is so well honed and organised that it accounts for more than 25% of global manufacturing. It is my firm belief therefore that there will be no US-China trade war on the scale that may worry us all – and tariffs are just a negotiating tactic, albeit a necessary one. I see China opening itself up more to US exports. The US-China trade deficit will start to close meaningfully when the prosperity of China’s middle-class increases and they demand services that the US can export to China. Therefore, it is not just in the US and China’s, but also in world’s interest, that a China –US trade war is averted
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“The more the State “plans” the more difficult planning becomes for the individual.”

Summary

Despite its high debt to GDP ratio, Italy’s main problem isn’t that it borrows too much – the issue is its non-existent growth. Italy, the third largest economy in the Eurozone hasn’t grown in any meaningful way for over two decades. Tinkering on the edges and paying lip service to reform mean that the outlook isn’t very bright for Italy. The European Central Bank’s (ECB) easy monetary policy over the last five years, may have pushed the recent GDP growth rate in Italy to +1.5%’ but what will happen when the ECB winds down its Quantitative Easing program and interest rates begin to rise? A re-run of the rising sovereign bond yield and questions about the viability of Italy’s economy are bound to resurface. In terms of equity markets, I don’t believe we have entered a new market regime, despite the recent market move. We are probably entering a transition phase and despite the market rhetoric, it is premature to conclude that the US Federal Reserve is behind the curve. The steady rally up we have seen over recent years may be behind us and what we will see going forward are moves both up and down i.e. welcome back to the two-way market. I still expect the S&P 500 Index to notch an +8-9% return this year – at least 200 points higher from the current level. What I am more concerned about is the rapidly deteriorating political equation in Germany. For the first time, the Far-Right Alternative for Germany (AfD) party has now surpassed the centre-left Social Democrats (SPD) in a national poll. How long before the AfD becomes the largest party in Germany? Inconceivable one might say, but not impossible. As Angela Merkel has moved leftward to occupy the space formerly taken up by the centre-left, the AfD has little competition for anything right of centre.
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“You can easily judge the character of a man by how he treats those who can do nothing for him.”

Summary

That was a very brief US Government shutdown this week. It lasted two days. Not that I am complaining. The agreement reached keeps the US Federal government funded through February 8, but it does little to resolve the contentious issues of immigration and government spending. The deal doesn’t preclude a similar shutdown next month. Markets care more about economic data than political “noise” and the data continues to be good. On the back of US tax reform, US growth is expected to accelerate and hopes have risen of wage increases. Global GDP growth is set to accelerate to over +3.5% from +3% in 2017. The global output gap is forecast to vanish in 2018 – the first time in a decade. The International Monetary Fund (IMF) estimates that, last year, 150 out of 176 countries managed to increase their exports. That is the highest share of nations on record and slightly higher than the peak reached in 2005.

So what could go wrong? The answer is: Trade wars. We got a taste of it on Monday when the US slapped steep tariffs on imports of solar panels and washing machines. President Donald Trump now seems ready to start implementing his “America First” trade policy. Be prepared to see more such trade-enforcements in the coming months. As top exporters, Europe, South Korea, Mexico, China, and Japan are all vulnerable to US trade tariffs and the “America first” policy. However, if trade wars become a global “thing,” with nations responding with tariffs and counter-tariffs of their own in a free for all, then the European Union (and Germany in particular), Korea and Mexico are most vulnerable, given their higher reliance on exports.

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“Just because you do not take an interest in politics doesn’t mean politics won’t take an interest in you.”

Summary

2017 was yet another superb year for the S&P 500 (SPX) index and the eighth full year of the current bull market run that began in March 2009. However, sluggish wage growth in the US has been a consistent theme of this economic cycle, confounding many, who believe a falling unemployment rate should herald higher pay for workers. Hopefully, the proposed cut in corporation tax in the US will drive investments and hence wages. If corporations however, use the tax cut to buy back stock and pay a dividend (as many have done so far), the impact of the cuts on GDP growth will not be so dramatic as consumption fails to take off. Unless the coal miner in West Virginia or the single mother in South Side Chicago has more to spend, businesses will have fewer reasons to invest. This equity market Bull Run will only come to an end when the US Federal Reserve starts raising interest rates aggressively, as was the case in 2006/07 and the yield curve inverts. The rule of thumb is that an inverted yield curve indicates a recession in about a year’s time. Yield curve inversions have preceded each of the last seven recessions. On Brexit, a breakthrough last Friday in the gruelling “divorce” talks between the UK and the European Union (EU) has paved the way for talks on trade. The agreement has significantly reduced the likelihood of a “no deal” scenario when the UK leaves the EU in March 2019. Bitcoin was and still is a gamble. At this point all I would say is: A fool and his money are soon parted. A fool and his Bitcoin may take longer, but they will be parted.
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