As August staggered to a close, global stock markets stabilised, with buyers returning to buy on the latest dip. Investors worldwide continue to have confidence markets will not collapse from the reversal of quantitative easing (QE) expected from the US Federal Reserve in September. But how long will this sanguine attitude last? If QE had a positive impact on the development of asset values when it was in full swing, that its reduction should theoretically present a significant headwind to asset values progressing from current levels.
The more imminent question is whether markets will experience a repeat of the 2013 ‘taper tantrum’, when both equity and bond values fell. Three schools of thought are being most discussed. The first suggests that as long as central banks proceed with caution and offer plenty of warning, broader financial condition should not tighten unduly. This view is based the belief that the improving economic environment should accelerates the turnover of money enough to compensate for the overall volume reduction of liquidity through the QE unwind. Thus, economic conditions should not deteriorate, but further asset price inflation beyond reasonable valuation levels should find less (liquidity) fuel.
The second view is even more straightforward. It suggests that since QE only inflated asset prices and never really improved economic conditions in the first place, its gradual withdrawal should have a negligible impact on the economy and only reign in runaway valuations. While we beg to differ somewhat, the outcome would be the same as with the first theory.
The third is the prediction of a collapse of bond markets, effectively triggering the second global financial crisis in just ten years. We see this as highly unlikely, given the recent, very cautious, track record of central bankers. On the contrary, we would be concerned that interest rate and yield curve normalisation progress might prove too slow, opening up more substantial pressures to general price inflation further down the line.
As usual our view is somewhere in the middle. We don’t expect major negative impacts on the global economy, but anticipate increased short-term market volatility. This could be heightened to more disruptive levels through any major geo-political crises, be that from the side of the North Korea tensions or any rash global trade suppression from an increasingly ineffective yet hard to predict President Trump.
The shift in global monetary policy – not ‘if’ but ‘when’
Whereas the Fed has broadly signalled intentions of unwinding QE, the European Central Bank (ECB) has yet to give any firm indication of its future policy. However, it now appears to be a matter of when, not if, central banks begin to unwind their position on QE. Answers to the related questions of how the central banks undertake any programme, and the potential economic and financial effects, are less clear.
As a consequence of QE, the central banks of the US, UK, Bank of Japan and the ECB now hold somewhere around $14 trillion of assets on their balance sheets. Clearly, removing this kind of economic stimulus must have some effect on markets over the medium to long-term. It is, in effect, a scale repatriation of assets off the bank’s balance sheets back into the market.
The minutes of the Fed’s July meeting revealed differences of opinion on when to begin shrinking the Fed’s balance sheet, together with concern among some over low inflation, which militates against a tightening (in money policy). A firm decision appears to have been postponed to the September meeting. But faced with a fast appreciating euro, and a rapidly improving economy, the ECB faces an equally difficult policy decision. In order to avoid market shocks, the unwinding of QE will require careful management over a long period, with a gradual approach to any sell-back consistent with managing money flows and interest rates toward target inflation.
The appreciating euro may hinder the ECB’s attempts to meet its inflation target of around 2%; a result of imports being relatively cheaper and a strong currency weighing on the Eurozone’s export volumes. The minutes of the ECB’s meeting also indicate that there is a risk that the currency could continue to appreciate. In any event, there is clearly a case for the ECB to consider reducing the level of economic stimulus. While the ECB would be right to wait until Eurozone growth is sustainable, we assume the ECB’s meeting in October will result in significant policy changes. This may not be a full balance sheet adjustment, but a reduction in the monthly volume of (net) asset purchases.
Is sterling’s weakness a bad economic omen?
Rather poetically, just as the symbolic chime of Big Ben fell silent in London, sterling came under renewed pressure, hitting lows not seen since October 2016. On a trade-trade weighted basis against a basket of the main global currencies, sterling touched 74.70, only a short hop from the 30-year support level of 73.65. Against the US dollar, the pound is at a two-month low, while against the euro things are even more dramatic, with sterling at an eight-year low.
Sterling’s slump has undeniably made UK exports more price competitive abroad. But, without certainty over Brexit, business confidence remains depressed, prevents much-needed business investment. This, together with slowing UK consumer demand (a result of currency-induced inflation), has led to mixed-to-disappointing economic news. The improved export competitiveness, meanwhile, is either lagging or simply hasn’t led to increased activity levels as expected.
However, prospects might not be as gloomy as they appear. In the short-term, the level of the current account deficit may deteriorate as higher import costs bite, although this is also dependent on improving exports as well. But, in the medium-term, a lower sterling and a softer Brexit approach may well make UK plc. more attractive to foreign direct investment.
As a result, sterling may have found its short-term base. It might even be deemed cheap and oversold, particularly in light of the apparent softening of the government’s stance on Brexit, as well as the positive (albeit slow) economic growth and the gradual improvements in the UK’s current account position. The weak pound could also help to address some of the UK’s problem of poor productivity, simply by making labour cheaper in the international arena. That does not let the country off the hook, however. The root cause of low productivity still needs to be solved, possibly through increased education and professional training spending, as well as further thoughtful and targeted infrastructure spending (not wasteful ‘tent pole’ projects). However, despite all the Brexit uncertainty, international business leaders and investors may begin to see value in the UK business assets, which, from their currencies’ perspectives, are now trading at much lower valuations.
A fistful of dollars
Few things affect currency markets and financial markets generally, quite as much as geo-political tension and events. Yes, intervention by central banks on interest rates and other economic fundamentals will all influence the course of a currency over the medium to longer term. But over the short term, currencies like the Swiss franc, the Japanese yen and even the US dollar tend to fluctuate significantly during periods of political instability and uncertainty.
As news concerning the tensions between the US and North Korea intensified, investors gravitated toward safe-haven assets like gold, which reached a fresh two-month high of $1,293. This coincided with equity market falls of between 2.0% and 3.5% in the same week. Nonetheless, it is arguably the course of currency markets that may provide a barometer for the likely extent and duration of these current geopolitical risks.
Political and other crises are often associated with significant movements in exchange rates, which reflect both increasing risk aversion (risk off), and changes in the perceived risk of investing in certain currencies (relative to the so-called safe haven assets and currencies). And, it seems this latest political skirmish is no exception.
The US dollar is (rightly) perceived as the global reserve currency, akin to a safe-haven asset. However, in our view, as the economic data for the US has been improving the currency weakness may be overdone. Moreover, even though the US Fed now appears to be retracing its steps on rate rises as US inflation remains subdued, we do expect the Fed to begin unwinding its QE bloated balance sheet – in earnest – later this year. This will likely impact markets, liquidity and the value of the dollar. Equally, continuing growth in the US labour market and marked improvements in net exports (perhaps also a reflection of the depreciated US dollar), provide further positive indicators for growth. In short, just as the consensus has swung behind the dollar weakness, we could be due another change in fortune.
UK house prices: grinding to a halt
The latest residential market survey from The Royal Institute of Chartered Surveyors UK (RICS) reveals that, at a national level, property price growth has “ground to a halt”. London saw the largest declines, but the RICS data now suggests falling prices have started spreading beyond the capital, particularly to the wider South East region. There are multiple drivers for this development, but, at its core, we believe it’s a combination of falling overseas demand, tighter Chinese capital controls, and tax changes that have affected buy-to-let investors and property owners with homes valued at more than £1 million.
It would seem that the increase in stamp duty and additional 3% charge for buy-to-let properties by former chancellor George Osborne has had a negative impact on more expensive homes, typically located in London and the south east. Stamp duty on a £1 million-plus home now costs a buyer £43,750, making moving homes more expensive.
But, as ever with the property market, short-term variations should be viewed within a longer-term perspective. The recent slowing in annual house price growth – to around 2% in July – stands in contrast to the rapid and unsustainable rates of near 10% back in March last year. Double-digit increases in property prices were becoming a potentially unhealthy mix in the view of the Bank of England (BoE), given the prospect of eventually higher interest rates and squeezed incomes.
The Bank of England may cautiously welcome a softer property market, as it would mean less stress for the general mortgage-rate-exposed public once rates do eventually rise. The government has also started to review its Help to Buy scheme, and could either replace it or end it sooner than its current expiry date of April 2021. Overall, economists are predicting house price growth of 2% in 2017, but this may prove to be optimistic given the growing pressures on UK households. Indeed, we expect house price growth to fall towards the 0% mark across the country over the coming months. This would suggest that, unless either the tax framework is reversed, or a favourable Brexit outcome suddenly materialises, this subdued backdrop is unlikely to change in the medium-term.
Happy tenth birthday to the Apple iPhone
The iPhone celebrates its tenth birthday this year. Not only did it change the fortunes of a computing company, it also altered the future direction of the telecoms and consumer technology sectors. Industry watchers now talk about smartphones in pre and post-iPhone eras. When it was introduced in 2007, some called the smartphone visionary, even magical. A number of industry watchers remained sceptical, as everyone ‘knew’ the paradigm: a phone had to have a keyboard. Steve Ballmer, Microsoft’s CEO in 2007, famously laughed off the competitive threat from Apple’s iPhone, saying it would be “the most expensive phone, by far, in the market place”, and noting it “lacked a keyboard for email” for business users.
He wasn’t alone in failing to appreciate what the iPhone represented. But in hindsight, the combination of an iPod, phone and Internet device with a pure touch interface proved revolutionary. Ten years later, with over 1 billion iPhones sold, and with Apple holding more than a quarter of a trillion dollars ($270 billion) in balance sheet cash, the argument has been well and truly settled.
Ten years ago, the world’s biggest firms came from the energy, financials and industrial sectors. But these have largely been replaced by Amazon, Google (Alphabet), Microsoft, Facebook and Apple. It can be easy to forget that each of the big five started life targeting single areas, like search for Google or selling books for Amazon. They have since grown well beyond what was originally conceived. Today, they no longer offer standalone products, and there no is no industry in which they are not competing. Music, movies, shipping, delivery, transportation, space and energy: the list keeps expanding. They are all pieces in a larger cohesive jigsaw we call a platform. These platforms support individual products by sharing data across multiple devices to be used as needed by the customer. Apple (iOS) or Google’s (Android) platforms dominate the mobile computing space and no one else can even compete unless they can plug into these systems.
The future that the big five are creating is built around global platforms that at times will overlap, but they are designed to allow expansion of future innovations like artificial intelligence, personal robots and automated vehicles. Perhaps we will look back a few years from now and talk about now as marking the era of the all-encompassing platform.
Thoughts on the Brexit papers
It has now been 14 months since the Brexit referendum result, but the government is no closer to substantial policy proposals for leaving the EU. In a recent candid interview, David Davis admitted that Michel Barnier, the chief Brexit negotiator on behalf of the European Union (EU) is “getting quite cross with us”. Mr Barnier himself said on Twitter that negotiations on Northern Ireland and the future of the customs union couldn’t begin in earnest until the size of the ‘divorce bill’ is agreed – a line that EU officials have been consistent on since the referendum but one that the government has remained coy about.
It had been hoped that two papers published in August would offer more substance. A Whitehall paper detailed the UK’s wish to remain part of the customs union for around three years after the official divorce date, while a further ‘position paper‘ ruled out a hard physical border between Northern Ireland and the Republic of Ireland. Unfortunately, there is widespread feeling that the government’s recent communications are more wishful thinking than genuine detailed policy proposal. For example, the government maintains that Northern Ireland’s food producers will be exempt from sanitary checks at the border, yet doesn’t make clear how this is possible in the context of EU health and welfare standards for imports from outside the customs union. There’s a sense that the government needs to be more robust in its thinking in order to have any hopes of reaching a compromise agreeable to both sides.
Perhaps more encouragement can be gained from the fact that both papers pointed to a considerably softer stance than has been previously taken by the government. Perhaps it is pure coincidence, but it would appear politicians are finally starting to listen to the messages that both the markets and business leaders have been delivering.
Business has become more vocal, calling for more certainty around Brexit, along with possible transition stages as part of the exit process. The call for an extended interim period is one that many business leaders have been making recently, arguing that a cliff-edge scenario could be disastrous for the UK economy. And the government has now heeded those calls, with one Whitehall official saying that “It should look and feel the same for business,” until the three-year interim is up. The change in tack on the customs union especially represents a victory for the soft-Brexit proponents within the Tory party, such as Chancellor Philip Hammond.
Our enthusiasm for UK assets is restrained in the short-term, but we are beginning to see the currency as potentially undervalued. When business, economists and politicians all start talking the same language, real progress can be made in the long run. The weak pound may have provided the necessary wake-up call, but a lack of long-term investment – and data suggesting that businesses are indeed right – may help to soften the government’s ‘hard’ Brexit stance. The fall in the pound does not tell the whole story. Things are not as bad as they may seem and perhaps, in four years’ time, when Big Ben’s silence breaks, the UK’s economic foundations will be on a more solid footing.