Whatever else we might say about 2016, we have never been short of things to write about this year. And so that fact remains as we approach the last month of the year. The whys and wherefores of Donald Trump’s Presidential victory need no further discussion here. The consequences very much do.
Perhaps the defining short term impact has been to change the mainstream perception of the Brexit vote from an aberration to part of a wider politico/economic sea-change. The assumption is now that populist movements will significantly shake up the status quo across a range of Western democracies. Francois Fillon may be the bookmakers’ favourite to win the French Presidential election, but if Marine le Pen emerges victorious, it will not feel like the political earthquake it would have done this time last year. The received wisdom in Germany is that the anti-EU AfD party is pleased that Angela Merkel has decided to seek a fourth term in office as she is seen as the perfect foil for its anti-establishment message.
What has been equally surprising in the last six months is the response of risk markets after the event. Post Brexit, there was an immediate sharp sell-off in domestically focused businesses, which mostly regained their poise in the following weeks. International businesses were re-rated because of the weakness in Sterling feeding through to the value of overseas assets and profits. Indeed, with the exception of adjusting for currency moves, equity markets have metaphorically shrugged their shoulders and got on with life. Similarly, the immediate response in the US equity markets to Mr Trump’s triumph has been to push equity values to record highs.
Having a loose-cannon with his finger over the nuclear button would appear to be less important than the expectation that he will spend lots of dollars he doesn’t have. Good for equities. Bad for bond markets. That Mr Trump will do anything that he claimed he would do on the campaign trail is now a moot point, but in many ways it does not matter. His instincts are pro-business, and he is unlikely to do anything that damages corporate America’s ability to make money in the short term. The long term is an entirely different debate.
Alongside the likelihood that the US government budget deficit is going to widen in the short term, the FOMC is now virtually certain to restart the upward trajectory of short term interest rates before the end of the year. Notwithstanding any Trump-induced hiatus in activity, recent data have shown that the US economy was trucking along nicely enough anyway to generate upward momentum in interest rates. The monthly releases of jobs growth, retail sales and inflation suggested previous momentum had been maintained, and the new housing starts number showed a stunning 26% leap, taking levels back to those last seen in 2007.
So 10yr bond rates in the US jumped back out to the level that they were at the start of the year which has fuelled a rotation not only out of bonds and into equities, but also out of large defensive companies into smaller more cyclical plays.
The question at the forefront of our minds is – can this be sustained? If it is, there are two drivers that will make it happen. In currency markets, much of our recent focus has been on Sterling’s weakness relative to other currencies. It always seemed slightly anomalous to us that as Brexit increased the risk of the whole European project dismantling that the Euro should be perceived as such a safe haven currency relative to Sterling. In part that is starting to unwind. Relative to the US Dollar, however, that is a different matter, and indeed the US Dollar’s general strength across the basket of major currencies reflects the clear difference now in monetary policy cycles. A stronger US Dollar (“USD”) carries with it the risk of it exporting inflation to developed economies around the globe – both in the form of direct imports from the US, but also from other areas like the Far East that use the USD as their reference currency. It should also stimulate demand from the United States – particularly vulnerable are assets that are now substantially cheaper in USD terms. But the risk of higher inflation should also come with higher interest rates. If politicians across Europe (including the UK) sense that the era of ultra-cheap government borrowing is coming to an end, they may be tempted to borrow and spend whilst they still can in order to address the clamour to do something (anything!) to help out those perceived to have been left behind by globalisation.
There have been a number of “wake up calls” to politicians since the Great Financial Crisis set in. Yet, none of them have posed any kind of existential threat to the political status quo. This is different. There is a genuine desire for change. Faced with these challenges, politicians normally respond by opening up the cheque book.
For much of the last eight years, we have simply implored politicians to avoid actively hindering the prospects of economic growth and recovery if they couldn’t do anything to support it. With slightly more expansionary fiscal policy, the current cycle of disinflation and stagnant wage growth could be broken. Nothing will address the burden of debt over the medium term as well as a bout of high nominal GDP growth.
Above all, we see the conditions that led the perverse situation of bond owners paying to lend money to borrowers as no longer as compelling. Low interest rates normally means low wage rates – and that does not get politicians re-elected. Many times over the last decade, commentators have tried to define a “new normal”. A return to “normal normal” works for us.
A short note on the market risks associated with a “hard Brexit”.
We believe that history shows that Britain is not a particularly racist, isolationist nor inward looking nation. Neither is it particularly susceptible to demagoguery or fanaticism. It’s legal system and governmental framework (whilst not perfect) are internationally recognised as creating an environment where others come to do business. The High Court ruling that parliament must approve the triggering of Article 50 is case in point to the safeguards that exist. The “will of the people” cannot be summed up by a single word answer to a single sentence question. In any democracy the will of the people can only be effected through parliament. That such a large majority of MPs do not wish to exit the single market suggests that the will of the people is not so easily deduced.
Change will come. But history suggests that the manner in which it is achieved, and the end result, will be a lot more considered than the current rhetoric implies.