UK investors might think it appropriate the first quarter of 2018 ended with a disappointingly damp Easter bank holiday weekend.
A quarter that started with so much optimism has ended with global markets in negative territory. The party was brought to an end by concerns that an overheating economy would push inflation and, in its wake, interest rates higher and more quickly than anticipated. After the euphoria and overconfidence dissipated, bouts of market volatility were triggered by the sort of concerns investors had previously felt comfortable dismissing.
That said, the rapid recovery from the recent dips tells us stockmarkets still have legs. From our perspective, this makes a lot of sense, given global growth rates remain healthy, just not worryingly frothy.
Overshooting economic growth momentum no longer poses a particular threat, but growth remains strong enough to expect gradually rising interest rates and bond yields. This in turn should prevent valuations from running away, as the competition of fixed interest bond yields returns. The continuation of economic growth and the generally positive outlook (despite the occasional political blowout) for the global economy leads us to believe that, over the medium term, returns will be back in positive territory for 2018.
Yet over the shorter term, volatility will continue to reign. While unpleasant, it is a helpful mechanism to purge unhealthy market developments and help capital markets gradually adjust to changing circumstances.
The challenge of the coming quarter will be to foresee market reaction to the changing but broadly normalising environment, as well as the timing of those reactions. Macroeconomic data over the coming weeks will be as important as the Q1 corporate earnings reports, which start to come out towards the end of April. Unfortunately, there are a number of additional factors, which will make it difficult to make short-term high conviction investment calls one way or the other.
Is the US/China trade war about trade, or war?
When President Trump announced tariffs on around $60bn of Chinese exports to the US, threatening an import tax of 25 per cent on key technologies, it was no surprise China retaliated by imposing $3bn of tariffs on US goods. The world then held its breath waiting for the next move.
But, as often happens with the Trump administration, events took an unpredictable turn. US officials requested China reduce its tariffs on US automobiles and give American companies greater access to its financial markets, as well as work to reduce the US’ trade deficit with China by $100bn by the end of the year.
Chinese officials responded promptly, saying the government would stop forcing foreign companies to hand over their technology and strengthen intellectual property rights. Sticking points remain, but the speed of progress and expression of intent has definitely alleviated concerns that an all-out trade war is looming.
For now, it doesn’t look like the Chinese leadership wants to launch a play for global domination, as their mild tariff response and quickness to compromise suggests. Nor would they be wise to, considering the damage it would do to their economic, technological and military development.
In the US, things are more complicated. On the one hand, talk of tariffs and unilateral action could all just be part of Trump’s “art of the deal”. His focus on China’s “unfair” practices and getting back American industrial jobs supports this.
On the other, what Trump represents – a growing antagonism towards globalisation and global rivals – suggests there is more to the dispute than anger at the Chinese ‘breaking the rules’. The ascendency of right-wing nationalists, such as John Bolton, to foreign policy positions speaks to this point.
But as long as we’re in the ‘deal-making’ scenario outlined above, markets should stay sanguine. Of course, rivals can work together for mutual gain – as the size and importance of the US-China trade relationship shows.
The question to consider is whether that mutual gain is more valuable than the power shift that comes with it. While both sides gain economically by maintaining trade, China advances its political power by maintaining the status quo by rapidly expanding its technology, military and economic and cultural influence.
By the same token, the US relatively loses more power. China’s stockpile of US government bonds gives it the stronger hand in trade disputes. But in global power terms, the US has far more to lose by letting the current set-up continue. That could well mean the US taking a harder line in trade disputes than many would anticipate.
Have the tech superstars lost their lustre?
Today’s market leaders reside within the technology sector. But is the recent sell-off in shares of the big technology firms a short-term blip or a signal of more permanent change?
The answer may shape the near-term direction of markets and long-term direction of the global economy. And the experience of the financial sector in 2007 provides a good analogy for technology stocks today.
Tech stocks have had it good in recent years, with high profit margins amid loose regulation. Since the lows of 2009, Facebook is up 413 per cent, Amazon 2,102 per cent, Apple 1,123 per cent, Netflix 5,349 per cent and Google 586 per cent.
But today’s generals are faltering, as investors ponder the growth implications from any new data or privacy regulations, which could curb what a firm can do with a user’s data. Without access to user data, these firms can't deliver targeted ads or grow profits, putting their lofty valuations under pressure.
It may be hard to think of Facebook, Twitter and Google as advertising businesses and not technology businesses, but that is what they are. Facebook and Google derive 98 per cent and over 90 per cent of revenues from ad sales respectively, and both firms now dominate the advertising sector. Collectively, Facebook and Google account for 25 per cent of all advertising sales worldwide, both online and offline. For Twitter, data licensing accounts for about 80 per cent of its profits.
But new regulations need not be the death knell of the current rally, merely the harbinger of change. For financials, MiFID I & II in Europe and Dodd-Frank in the US have led to higher costs of doing business, but have also created new opportunities, even if profitability is unlikely to match peak levels.
Likewise, new regulations may not break current tech business models, but change is most likely in the air. Perhaps the era of personal data sovereignty is upon us and that too will create its own opportunities; more open versions of social media may emerge. Maybe new regulation could eventually help provide investors with greater clarity over growth, even if growth rates are more modest than in the past.
Brexit transition agreement reached
March saw the UK government confirming a transition period of effective UK membership in the European Union (EU) beyond the Article 50-triggered Brexit date in March 2019.
EU law will remain in place in the UK in full until at least January 2021, so the perilous cliff-edge scenario for businesses unsure about future trading conditions can be avoided.
Other provisions include EU citizens arriving during the transitional period being granted the same rights as those already here (something the prime minister previously ruled out), the UK’s ability to sign new trade deals with other countries, continuing British contributions to the EU budget throughout the transition period and the retaining of EU fishing quotas. These last two proved decidedly unpopular with the Brexit hardliners.
In truth, the fact the British government has made these compromises is symptomatic of their tricky negotiating position. The UK needs to compromise or it will lose access to its largest trading partner. The EU, on the other hand, has comparatively little reason to compromise; the cliff-edge is much smaller for them.
While fish quota crusaders bemoan that the EU fishes in our waters much more than we do in theirs, they omit the fact that most of the fish Britons catch gets sold to the EU.
Any attempt at limiting European access to British waters could easily be met with retaliatory tariffs. Besides, in GDP terms Britain’s fishing industry is miniscule in comparison to areas like the financial sector. What little deal-making power the government has would be more beneficially used reaching concessions. This agreement appears largely an acknowledgement of that.
Despite all the time spent bemoaning ‘unacceptable’ measures, as time goes on the most likely Brexit outcome looks softer and softer. Forgetting political inclinations, this will likely be the most helpful option from the perspective of business certainty, purely because it represents a continuation of the status quo.
As if to confirm this view, the announcement prompted sterling to rise against the dollar, bringing it firmly into territory not seen since before the referendum. At these levels, British exporters should still enjoy the relative advantage they’ve had over European competitors post-referendum owing to sterling’s low euro value, but potentially without the associated spiralling inflation costs.