As September drew to a close, it was something of a relief that much of what could have gone wrong, did not. The global economic recovery has made consistent progress, with the eurozone in particular coming up strongly and taking over the western growth leadership baton from the US.
The same cannot be said about capital markets – and politics. Investment returns have, despite stronger economic data and corporate profit growth, only very slightly moved beyond the healthy levels already achieved at the end of May. This ‘market breather’ was what we had anticipated and, on the back of the strengthening macro-economic outlook, we would normally look optimistically to the rest of the year.
But this is not a normal year, both in political terms and now also in terms of natural disasters. In purely economic terms, for wealthy countries like the US natural disasters create data fuzziness, as they first slow down activity levels in the affected regions, before rebuilding supercharges them further down the line.
Politics and geopolitics are less predictable. President Donald Trump remains the wildest of political wildcards, but given how little he has been able to achieve thus far, and how much public support he has lost in the process, fears of global trade wars have greatly reduced.
The same cannot be said about geopolitical tensions and here Trump remains an uncertainty accelerator. Kim Jong-Un’s ambitions to have North Korea recognised as a nuclear arms power cast a shadow on the short to medium-term global outlook. The surprising rally in bond markets earlier in the month revealed the more cautious part of the capital markets is beginning to take the threat of a thermo-nuclear conflict seriously.
There is plenty ahead to keep capital markets in suspense, not least the upcoming quarterly corporate earnings announcements and the central banks’ determination to bring the era of extraordinary monetary easing to a gradual end.
Deutschland 1: Rest of the World 1
Germany’s general election results have given Europe something to think about. The two leading German parties, the centre-right CDU and centre-left SPD, had governed for the past four years under a coalition government. But in the recent election the parties suffered heavy losses, as 12.6 per cent of votes went to the ultra-right populists of the Alternative für Deutschland.
However, while the success of the AfD party is said to be a response to Chancellor Angela Merkel’s relaxed immigration policy, the regions in which AfD gained most traction are actually those with the lowest levels of immigration.
For the sake of EU reform progress, we hope Germany’s politicians do not turn inwards and risk being distracted by domestic politics for too long. Germany remains the engine of the eurozone, accounting for 28 per cent of the eurozone economy, and has a material impact on pan-European economic activity, aggregate growth and overall inflation.
Whereas other countries are just starting their economic upswing, Germany has been steadily growing for some time, which has helped to underpin enhanced eurozone economic activity, business investment and growth, as well as much-needed wage-driven inflation.
Even though its economy has been performing well, business investment has yet to gain real momentum. Meanwhile, adverse demographics could weigh on long-term growth prospects. Indeed, according to the International Monetary Fund, GDP is expected to grow by just 1.8 per cent in 2017 and 1.6 per cent in 2018, but “over the medium term, population ageing and slow progress on structural reforms is expected to weigh on growth."
Germany is well placed to further develop its own economy and increase consumption (through lower taxes, higher wages, public investment and otherwise), and this need not be at the cost of its competitive trade position. Indeed, the more Germany effectively deposits abroad, the less it will have left to invest in its own economy. The current account surplus could mean investing is occurring abroad rather than at home –perhaps a sign the country is less attractive to investors.
Encouraging more domestic consumption will reduce the reliance on exports and decrease the trade surplus. An appreciating euro might help in this regard. If the German trade surplus has bolstered savings, we believe it prudent to release more of that saving to (domestic) investment. This should underpin economic growth and, critically, promote investment and growth in the lagging regions in Eastern Germany that most heavily leaned towards the AfD in the elections. This would be in Germany’s economic and political interests, as well as the economic interest of its trading partners.
We agree with Trump – for once
Eight months into his presidency, Trump’s policy achievements remain virtually non-existent. His administration appears to be playing like a Washington DC version of Groundhog Day. With efforts to repeal and replace Obamacare again kicked into touch, it’s back to tax reform. But will it be any different this time?
Under the latest proposals, US companies will pay a tax rate of 20 per cent, down greatly from 35 per cent but still some way off the 15 per cent promised last year. For individuals, the current tax reform proposal is vaguer, but would shrink the seven different tax bands that apply to US citizens to just three: 12 per cent, 25 per cent and 35 per cent. However, White House officials have said they haven’t yet decided the income bands these rates would correspond to and thus this change may or may not actually result in lower income taxes overall.
There were two further points of note. First, there was no mention of the protectionist ‘border adjustment tax’ which could have risked triggering global trade wars. Second, it would mean moving the US general taxation approach from global to territorial. Companies operating in the US would only pay tax on profits generated there – the standard throughout most of the world. The current system sees US companies paying tax on their total profits generated worldwide, which inevitably leads to double taxation.
The effects of reform success would be huge. Research from Goldman Sachs indicates tax cuts would see an additional boost to 2018 S&P earnings of 11.5 per cent if passed this year. As ever, the only question is whether it will happen. Trump’s fractious relationship with the congressional Republican party has handicapped his ability to implement policy. Even now, according to prediction markets, the implied odds of tax reform stand at 30 per cent, unmoved in recent times. However, while Republicans may have had a wide range of positions towards repealing Obamacare, they are firmly united in their desire for tax cuts. With the fine tuning of taxation bands also still to be defined, the proposal has enough room for negotiation to even bring in the Democrats.
Much as markets overestimated the probability of tax reform late last year, they seem to be underestimating it now. If tax reform does actually come, it will provide a boost to earnings of US corporates which would suddenly make US equity valuations appear a lot less extended than they are today.
Is the Bank of England bluffing on rate hikes?
The Bank of England's (BoE) Monetary Policy Committee is in quite a pickle. On the one hand, weak business investment and inflation-squeezed consumers are hampering the UK’s economy to the point where in growth terms the rest of Europe is suddenly overtaking. This would call for more economic stimulus, keeping interest rates low for longer. On the other hand, the UK’s current inflation issue is almost entirely caused by the weakness of sterling and the price rising effect this has on all imported goods and services. The BoE is explicitly tasked with guarding the UK’s price stability. The prospect of higher interest rates usually strengthens a currency – and calls to raise interest rates.
With unemployment continuing to fall to lows last seen 40 years ago, and the combination of low rates and improved job security tempting consumers to take on more credit card debt than may be good for them once rates do rise, the BoE can also point to further reasons to raise rates sooner rather than later.
The ideal scenario would be where the central bank could create the expectation of rate rises which strengthens the currency, but doesn’t actually have to raise rates which may still be harmful for the wider economy. But the formal warning issued in September that rates would rise before the end of the year has been dismissed in many quarters as a bluff.
This means the BoE’s credibility is now at stake, and if rates do not rise before the end of the year, sterling could plummet again. We therefore believe it highly likely we will get a 0.25 per cent rate rise this year. However, this would simply return rates back to where they already were for nearly eight years, before last year’s EU referendum. Thereafter, further rate rises will once again be very dependent on the shape of the UK economy.
We would not be surprised if the BoE economists are putting their hopes into the same charts we have been poring over. Those charts are telling us there is a good chance the UK’s economy will at long last enjoy a demand boost from export growth, as the weakness of sterling is finally leading to a marked improvement in order books.