The realisation is finally dawning on many in Europe that a No Deal Brexit would hit the EU very hard and is therefore an undesirable outcome. After hoping and wrongly presuming that the UK would cancel Brexit (a ludicrous thought that only highlights the gulf in understanding between the UK and the Continent), it is only now – after being convinced of the likelihood of collateral damage in its own country – that Germany is taking a more conciliatory approach. An extension of Article 50 is likely to give enough time to conclude a deal. I see a second referendum as the least likely outcome, with a general election as more likely. Across the pond, it is hard to see a resolution to the US Government shutdown other than President Donald Trump declaring an emergency that would let him reallocate funds that Congress has appropriated for military construction in order to build his wall. Of course, the Democrats will sue him, but at least the government would re-open and both sides could declare victory. US-China trade negotiations are entering a crucial stage and the likelihood of a Deal seems quite high. It is clear that trade wars are not easy to win and Trump is ready to fold, declare victory and focus on getting re-elected. He wouldn’t want China tariffs to be part of the 2020 campaign. China, on the other hand, would be relieved. Meanwhile in Europe, Germany is on the brink of a recession, as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. The Eurozone is in a precarious position. Germany ought to embark on deficit spending and flex the rigid “growth and stability” pact to get the whole Eurozone out of its slow decline. Will they? Don’t hold your breath.
Deal, No Deal or Second referendum?
Last week, Annegret Kramp-Karrenbauer the head of the ruling Christian Democratic Union (CDU) party in Germany and the likely next Chancellor, as well as over two dozen other German luminaries from the fields of politics, art, industry and sport issued a plea to the UK to change its mind and stay in the European Union (EU). The letter published in The Times of London marks a significant shift in Berlin’s tone. It talks about the role of Britain – “we realise that the freedom we enjoy as Europeans today has in many ways been built and defended by the British people” and its continued importance to Europe’s future – “Without your great nation, this continent would not be what it is today: a community defined by freedom and prosperity.” And goes on to implore –“We would miss Britain as part of the European Union, especially in these troubled times. Therefore, Britons should know: from the bottom of our hearts, we want them to stay.”
A bit too late in the day, I’d say. Where were these good people before the referendum in 2016? That was the time for the esteemed leaders of the EU to give then UK Prime Minister David Cameron a worthy deal that he could sell to the British people. Instead, they gave him a bag of crisp hot Brussels air which Cameron tried to present to the British voters as a “great win,” and was repudiated.
The realisation is dawning on many in the EU that a No Deal Brexit would hit the EU very hard and is therefore an undesirable outcome. After hoping and wrongly presuming that the UK would cancel Brexit (a ludicrous thought that only highlights the gulf in understanding between the UK and the Continent), it is only now – after being convinced of the likelihood of collateral damage in its own country – that Germany is taking a more conciliatory approach.
Anyone with any interest in Germany and the EU and where they’re headed, would be well served to read the masterful analysis of the topic in the book Berlin Rules: Europe and the German Way. It is written by Sir Paul Lever, former British Ambassador to Germany and a senior member of the European Commission in Brussels who attended all European Council meetings from February 1979-85. In its institutional form, he suggests that the EU looks and “will continue to look like Germany” and that its “leadership of the EU is geared principally to the defence of German national interests.” His conclusion is that Germany will prevent the creation of the “all-powerful European super-state that ” and in 20 years’ time many (Brits) will have forgotten Britain was ever a member of the EU to make them regret their choice” and “others… may wonder what all the fuss was about.” I recommend the book highly.
Last week also saw UK Prime Minister Theresa May suffer the largest parliamentary defeat in British political history, as the House of Commons rejected her Deal on Europe by 432 to 202 votes. By any yardstick, the defeat that May suffered is entirely of her own making. Tin-eared, distant, and reticent don’t even begin to define the approach she took to agreeing a “Withdrawal Agreement” with an intransigent EU. May couldn’t persuade a starving man to eat with the approach she has taken thus far. Tories must fear a terrible drubbing at the elections, if May continues as PM. Thankfully, she has promised she won’t lead the Tories into the next election.
So, what’s next?
To those who say “No Deal” is off the table or Brexit could be cancelled, I say this – No deal is not “on the table” but it is in the Statute Books. The European Union (Withdrawal) Act 2018 was passed through both Houses of Parliament and became law by Royal Assent on 26 June 2018. 498 of 650 MPs voted to trigger Article 50 i.e. a clear and overwhelming commitment to leave the EU. Over 80% of MPs subsequently were re-elected in 2017 on manifestos pledging to implement Brexit. Legally, in the absence of an agreed deal, the UK, therefore, will leave with “No Deal” on March 29, unless the Article 50 deadline is extended by the mutual agreement of the EU and the UK. A No Deal, however, doesn’t mean “crashing out” as some like to fear monger. It just means agreeing a set of side deals and a temporary return to WTO rules for trading, until new trade deals and arrangements are worked out between both parties.
As I said on Bloomberg TV last week- I still believe that the UK will leave the EU with a deal. An extension of Article 50 is likely to give enough time to conclude a deal. There will be a transition period in which the UK will be part of the customs union and at the end of the transition period, the EU and the UK will move on to a Free Trade Agreement (FTA). As far as the UK is concerned the “freedom of movement” of workers is a red line and will not be up for negotiation.
The EU doesn’t want a No Deal scenario. Nor does the UK for that matter. A No Deal would be very inconvenient for the UK in the short term, as details of new arrangements are worked out, but it would be a growing tragedy for the EU to lose a nation it has a big trade deficit with. Besides a No Deal at, minimum, means:
• Immediate halt to the £39 billion “divorce payment” to the EU
• No further annual contributions of £13 billion to the EU budget
• The EU’s entire exports to the UK – £341 billion last year would be put at risk
• A severe macroeconomic calamity for Ireland
This, at a time when the economic woes of Germany (the driver of the EU 27) are growing as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. A German slowdown is already ringing alarm bells in Brussels and at the European Central Bank (ECB).
Weaker German growth is very bad news for the rest of the European continent, where many economies are linked to the demands of the German export machine and German consumers. For instance, Germany is France and Italy’s top export destination with 15% of total French exports and 12.5% of total Italian exports going to Germany. A slowdown in Germany would hit France and Italy hard. The possibility of a No Deal or messy Brexit, populism and unrest in France, mounting US protectionism and the slowdown in China all are major headwinds for Germany and the Eurozone. China is Germany’s largest trading partner ahead of the US. If that’s not enough, cast your mind back to last July and the Trump-Juncker conference that temporarily diffused the risk of damaging tariffs on EU auto exports to the US, in return for the EU pledging to work to achieve “zero tariffs, zero non-tariff barriers, and zero subsidies on non-auto industrial goods.”
Fast forward 6 months, and the EU is now being accused by US officials of dragging its feet on trade talks in the hopes of waiting out the Trump administration. It won’t end well if you know what Trump is like. President Donald Trump is about to conclude a trade deal with China. With the Mexico-Canada and China deals completed, all efforts and urgency will go into taking on what Trump likes to call the EU’s “unfair trade deal” with the US that “robs” the US and treats it like a “piggy bank”. Expect fireworks soon.
I see a second referendum as the least likely outcome. A general election is more likely than a second referendum. We know that the country is divided roughly down the middle – half favouring Leave and half favouring Remain. A new referendum will only frustrate those who voted to leave and waste valuable time and resources. Even if there were a second referendum, in my opinion, Leave is likely to win again. In a tweet, Robbie Gibb, Director of Communication at 10 Downing Street reminded us as much – “1.9 million Leave voters say they would now vote to Remain. But 2.4 million Remain voters would now vote to Leave. The country hasn’t changed its mind.” Remember also that the voters were told the Brexit referendum was a “once in a lifetime vote” and 3 years is not a lifetime by any stretch of the imagination. For many in the UK – whether Remainer or Brexiteer, a second vote amounts to a violation of democracy.
As for GBP/USD, the UK economic data on a relative basis is getting better and the US is unlikely to raise rates until the summer given concern about the economic slowdown in the US. Therefore I see GBP/USD getting to 1.32 by June, creeping up to 1.36 or higher by September and 1.40 or higher next year.
Economy & Markets
The US Government shutdown that started before Christmas carries on and is now the longest government shutdown in US history – beating the 21-day clash between President Bill Clinton and the Republican Congress over federal spending that stretched from December 16, 1995, to January 5, 1996. The shutdown is now entering its fifth week and shows no signs of coming to an end. Trump is adamant on getting the $5.7 billion funding he needs to fulfil the campaign pledge to build a wall on the US-Mexico border. Democrats on the other side buoyed by their successes in the mid-term elections, are refusing to grant Trump that money. Democrats insist – reopen the government first, talk later. Trump insists – fund the wall first, reopen the government thereafter. The deadlock continues.
In a televised speech over the weekend, Trump made an important concession – calling for $5.7 billion in funding for the wall in exchange for a three-year protection from deportation for young immigrants illegally brought to the US as children, known as Dreamers. US Senator Chuck Schumer and House Speaker Nancy Pelosi rejected this outright with Pelosi calling it a “non-starter.” Schumer shut down the government in January 2018 for 3 days because protection for Dreamers was not in the budget for 2018. Now he’s refusing to co-operate and open the Government, when the protection for Dreamers is included in this latest offer from Trump. It’s hard to see a resolution other than Trump declaring an emergency that would let him reallocate funds that Congress has appropriated for military construction to build his wall. Of course, the Democrats would sue him, but at least the government would re-open and both sides could declare victory.
Meanwhile, the US government may be shut down, but the markets are off to the races. The table below indicates the stellar run so far in 2019, albeit given the sell-off in December, the rally is still only a comeback or a recovery rally.
While Energy (XLE) leads all sectors at +11.3% on the back of crude oil’s +24% surge, Brazil (IBOV) leads all countries in the matrix above with a YTD gain of +11.2%. Remember Energy was the worst performing sector last year down -20.6%.
The Q4 earnings reporting period got underway last week in the US. This season couldn’t have started more differently than the last, when investors were selling anything and everything, and it culminated in the S&P 500 index falling off a cliff in December. Less than 100 stocks have reported so far, so there’s still a long way to go. Of those, 69% have beaten consensus analyst estimates (a strong reading) but only 49% have beaten top-line consensus revenue estimates (a weak reading). The revenue beat has been falling for the last four quarters and points to a slowdown in the economy – which is not a bad thing overall, as it will keep the US Federal Reserve (Fed) from raising rates anytime soon.
Recall, the Fed last month raised its benchmark Fed Fund Rate (FFR) by +0.25% to a range between +2.25% and +2.50% and indicated it could raise rates twice this year. At the press conference that followed, Fed Chairman Jerome Powell struck, what the market thought, was a hawkish tone and risk assets promptly sold-off. The sell-off just kept getting worse into the holiday period. Since then, Powell and his colleagues at the Fed have spoken at various forums to allay the worries that the Fed is on a pre-set path. “There is no pre-set path for rates,” Powell said during an appearance at the Economic Club of Washington, D.C. ten days ago. He added – “We’ll take into account tightening financial conditions, which we’ve seen, and we’ll also lower our rate path and try to have monetary policy offset weakness before it even happens.” I do not see a US rate hike until June at least.
US-China trade negotiations are entering a crucial stage and, in recent days, Trump has made positive remarks on the prospects of striking a deal. “I think we’re going to be able to do a deal with China” he tweeted last week. The U.S. and China are seeking to resolve their dispute ahead of a March 1 deadline, when in case of no deal, the tariffs on $200 billion of Chinese goods are scheduled to jump to 25% from the current 10%. In a very positive, and rather surprising turn of events, The Wall Street Journal reported last week that US officials are debating ratcheting back tariffs on Chinese imports, as a way to calm markets and give Beijing an incentive to make deeper concessions in a trade battle that has rattled global economies. This seems a striking turnaround for an administration that hasn’t lifted steel and aluminium tariffs on its closest allies and is still threatening them with a 25% levy on car imports. Treasury Secretary Steven Mnuchin has talked of eliminating the tariffs on $200 billion of Chinese goods and raised the possibility of lifting tariffs on an additional $50 billion of Chinese goods that have been in effect since August. However, Mnuchin faces resistance from US Trade Representative Robert Lighthizer, who is concerned that any concession could be seen as a sign of weakness. In the past, Trump has sided with Lighthizer on tariffs, rather than Mnuchin. But this time, he has made it clear he wants a deal—and is pressing Lighthizer to deliver one, according to people familiar with the discussions. So it seems trade wars are not easy to win and Trump is ready to fold, declare victory and focus on getting re-elected. He wouldn’t want China tariffs to be part of the 2020 campaign. China, on the other hand, would be relieved and of course trade fairly with the rest of the world as soon as it starts exporting of high-quality products – telecom products an example, and Chinese companies start outsourcing cheap labour to other countries. This is pretty much what happened with Japan decades ago, as it went from making “knock-off” products in the 1960 and 70s to innovative new products in the 80s and the 90s and became a world leader in manufacturing.
Meanwhile in Europe, as mentioned above, Germany is on the brink of a recession as it is hit by weaker exports to China and elsewhere, as well as softer demand at home. Germany’s economy shrank in the third quarter of 2018 for the first time since 2015. Germany is one of only a few Western economies to have had huge success exporting to China. It is not only German car manufacturers that are impacted, but some 5,200 German companies operate in China, many of them midsize engineering firms that deliver the capital goods that China has used to power its factories and build its infrastructure. The Eurozone is in a precarious position. Germany ought to embark on deficit spending and flex the rigid “growth and stability” pact to get the whole Eurozone out of its slow decline. Will they? Don’t hold your breath.
So in light of all of the above, my allocation still remains overweight to US equities. I also feel very positive about Emerging Markets (EEM US) and particularly the China tech stocks (Alibaba, Baidu, Tencent, JD.com) and stocks with China exposure (Micron Technology, Apple etc.). As for US sectors, I stay overweight US Financials (XLF), US Communication Services (XLC) and US Healthcare (XLV)
Finally just to remind you about what I wrote in the November Market Viewpoints. Since 1946, there have been 18 midterm elections and US stocks were higher 12 months after every single one. Yes, every single one. That’s 18 for 18. Since 1946, stocks have risen an average of +17% in the year after a midterm election. We’re also in the third year of a presidential term, which is historically the strongest year for stocks. You will note that the performance of stocks in the third year of a presidential term beats all other years by a long shot. Therefore, I recommend you stay long equities.
Other stocks I like: 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), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM 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), 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), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US), Lam Research (LRCX US), VINCI (DG FP).
Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital