Market and Economic Commentary: “Every cloud has a silver lining”

Politics continues to dominate both stock market and general economic sentiment. In particular, the continuing trade dispute between the USA and China is a focus of concern for investors, as higher import tariffs start to come into effect. Sentiment has also been impacted in the technology sector by the US targeting Chinese telecoms giant Huawei, although an uneasy truce seems to have been agreed between President Trump and Xi Jinping when the two Leaders met in Japan recently. The US are also threatening to raise tariffs on goods from Mexico, further raising the risks to global trade flows.

Tensions have also soared between Washington and Tehran with President Trump signing off a new round of “hard hitting” sanctions against Iran. The measures will specifically target Supreme Leader Ayatollah Ali Khamenei and other Iranian officials. Just as a crack of light breaks through the US-China trade war storm clouds, the situation worsens in the Middle East with a continuation of Mr Trump’s self-created geopolitical game of Whack-a-Mole. Will Europe be Mr Trump’s next target for trade tariffs?

In the UK, prime minister Theresa May stepped down after being forced to resign realising that she could not get her Brexit Withdrawal Bill passed in Parliament, and ahead of the European Parliamentary elections in May. These elections demonstrated the extreme polarisation of British attitudes towards EU membership. The newly formed Brexit Party, led by former UKIP leader Nigel Farage was the overall winner, with 29 seats, on a clear “Leave” stance, whilst the Liberal Democrats came second with 16 seats, with a clear call for a “People’s vote” or second referendum to remain in the EU. The traditionally dominant UK parties, Labour, and especially the Conservatives, performed poorly, reflecting voters’ dissatisfaction with their stance on Brexit.

Despite recent personal issues, Boris Johnson remains clear favourite to succeed Theresa May as the next British Prime Minister although the entrepreneurial flair and public appeal of Jeremy Hunt cannot be underestimated. The stage is now set for a battle between the former Mayor of London and the Foreign Secretary as they vie for support of about 160,000 Tory party members with the result being announced on 22^nd July.

Mr Johnson, leader of the Brexit campaign in 2016, has already stated that if he were to move into No10, Downing Street he would not honour the £39billion “divorce bill” his predecessor had negotiated with the EU unless a better exit deal was offered. His promise to deliver Brexit on 31^st October, Deal or No Deal is likely to find favour with the Tory party membership some 80% of whom are in favour of Brexit. Jeremy Hunt’s more pragmatic approach might be less appealing to the Brexit hardliners.

According to ‘PredictIt Prediction Market’, as Mr Johnson’s chances of success have increased, the progress of sterling on a trade weighted basis has weakened in inverse proportion. With Mr Johnson as PM a “No Deal” Brexit has once again become a real possibility and sterling has taken fright. However, as the saying goes, “Every cloud………….” and a weak currency, whilst being troublesome for some parts of the domestic economy, inflates the value of overseas earnings for UK exporting companies and FTSE 100 companies derive more than 70% of their earnings from overseas.

For all the noise and confusion, there are five possible Brexit outcomes. The first is that parliament forces a general election, stopping a No Deal exit with a vote of no confidence. In turn, this would present the possibility that Nigel Farage’s Brexit Party divides the Tory vote, handing power to Jeremy Corbyn.

The second scenario is that, to avoid such an election, the pro-Brexit European Research Group finally backs the Withdrawal Agreement given that Brexiteer Boris and not Remainer Theresa would oversee the next stage of UK-EU talks. Alternatively, the UK could leave with No Deal—–after the House of Commons, despite the Speaker’s efforts, fails to find a Parliamentary ruse to stop it. The fourth possible outcome is a second referendum. And the fifth scenario could see parliament revoke article 50, hoping that Brexit just goes away. These last two scenarios would be disastrous and a constitutional outrage.

At the time of writing the Brexit situation remains deeply uncertain and it is neither possible to rule out a No Deal Brexit on the one hand nor even a no Brexit scenario on the other hand. The best approach is to resist the temptation to forecast as a final decision may come very late and involve unexpected developments,

With all eyes in the UK focused on the Conservative Party leadership race, it is easy to overlook the changing of the guard at the European Central Bank (ECB). The transition is now underway and is arguably even more significant for the future of Europe and the eurozone. Following in the footsteps of Marion Draghi as ECB president will be no mean feat. Mr Draghi navigated the challenges of the European debt crisis with bold and creative policy moves, famously declaring that he would do “whatever it takes” to preserve the single currency and the survival of the eurozone. The successful candidate must reinforce the message of stability and will have a host of first day challenges in his in-tray upon arrival. Top of the list will be how to deal with stuttering European economy, negative interest rates, stubbornly low inflation which has decoupled from target as well as Italy’s fiscal trajectory.

All this political uncertainty combined with recent weaker economic growth data and talk of a possible recession in the US, provides stock markets, and the glass half empty brigade, with plenty to be concerned about. The “Wall of Worry” has seemingly become steeper and steeper. Understandably, stock markets hit a softish patch in May/early June primarily on concerns about the potential impact of the escalating trade dispute on economic growth prospects. Sentiment in the UK has also been impacted by continued Brexit and political uncertainty.

However, a slowdown in economic growth and an absence of inflationary pressures, allows central banks a free reign to loosen monetary policy and markets are now discounting a cut in US interest rates. This leads markets to be dominated by a ‘low for longer’ dynamic. Once again, “Every cloud…….”, as cheap money looks set to continue for many years to come favouring both corporate and individual borrowers and mortgage affordability.

Polarisation is not just a feature of politics. The stock market is polarised between high quality and faster growing businesses on the one hand, and more cyclical or in some cases challenged businesses on the other. Morgan Stanley calculates that “high quality”* companies are currently priced at a 40% premium to their long run average across Europe, and close to the level they reached at the top of the Technology, Media and Telecoms bubble at the end of the 1990s in the US. In these times of low for longer interest rates, negative yields on government bonds, benign inflation and anaemic economic growth, Investors are prepared to pay a high price for quality growth. Some fund managers are even expressing confidence that their portfolios of quality stocks are “reassuringly expensive”.

Benjamin Graham, who is often referred to as the father of value investing, said that in the short-term, stock markets are a voting machine, but in the long term they are a weighing machine. As in politics, the stock market is voting for extremes. Because of the flows of money into perceived higher quality growth companies, many perfectly sound businesses are being neglected and are trading at exceptionally attractive levels.

Diversification is more important than ever and by prudently building a balanced portfolio of these value companies combined with top quality growth companies, through high conviction fund managers, Clarion believe that we can continue to generate a high level of income for our clients and strong total returns over the medium term.

*“High Quality” companies are normally defined as those with higher than average returns on capital employed and low volatility of earnings.