Friday, 24th of May 2019
“You may have to fight a battle more than once to win it.”
– Margaret Thatcher
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Another bad week in markets is coming to a close. The S&P 500 Index was down -1.3% by market close on Thursday, while other major indices have fared little better, or worse. The sudden collapse of US-China trade negotiations in early May, at the very moment when most investors expected officials to announce a significant breakthrough, continues to reverberate through markets. The subsequent tit-for-tat tariff measures and the ratcheting up of aggressive rhetoric from both sides have compounded fears that the worst of the Trade War is yet to come. President Xi Jinping recently called for a new ‘Long March’ in China’s current confrontation with the US, evoking the sacrifices made by the Red Army (a precursor to Mao’s PLA) during its strategic retreat in the face of Chang Kai-shek’s massively more numerous Nationalist forces in the 1930s. Only 7% of the 100,000 soldiers who set out from Jiangxi province in October 1934 survived what was to follow – a gruelling 9,000km journey through China’s mountainous interior. Their grit and determination have long been mythologised in Chinese propaganda and the message from the President is clear: any sacrifices expected of you today pale in comparison with those of your revolutionary forebears, but you can still be part of the same heroic story by matching their resolve. Chinese newspapers and broadcasters have begun to echo these sentiments, exhibiting a clear shift to a more overtly hostile and nationalistic tone. Even revolutionary cinema from the Mao era is making a comeback, with old classics about the Korean war (i.e., the War to Resist American Aggression and Aid Korea) airing in consecutive prime-time slots on China Central Television (CCTV).
Given the sharp escalation in trade tensions between the US and China and the hardening of the latter’s negotiating position in recent weeks, the prospect of a major deal to end the stand-off soon is dim. Most probably, we are now in for a protracted period of significant trade policy uncertainty that will have a chilling effect on investment, even in sectors and markets that have little direct exposure to trade with either country. The lurking threat that the US-China Trade War will deepen further or suck in other blocs, like the EU, will hang over markets until momentum shifts back behind the negotiations. At Bedrock, we are glad to have bought protection when volatility was cheap, given the unpredictable state of play.
Nevertheless, we hold to our positive medium-term outlook for equities, particularly in the US and EM. America is growing strongly (as highlighted in the Fed’s April minutes released this week) and much faster than all other developed economies. Moreover, this is not only thanks to the short-term effects of tax reform in 2018 or more recent inventory stockpiling amid the global trade uncertainty. The labour market is booming with unemployment falling (despite already being at an all-time low) and wages rising in line with surging productivity. At the same time, the positive Q1 results season shows the broader resilience of US corporate earnings to slower global growth and an uncertain trade environment. This reassures us that the fundamental picture is sound, even if there is short-term impact from deteriorating US-China trade relations. In EM, we also see significant value and positive trends. It goes without saying that demographic tailwinds and rising living standards translate into a higher emerging market equity risk premium to capture by being structurally overweight the region on a long-term basis. However, the ferocity with which the commodity price collapse tore through many EMs from 2014 to 2016 – toppling governments, bankrupting inefficient businesses and forcing supply-side reforms – left only the best firms standing at the end. Interest rates are now falling across much of the EM universe, stimulating at least nascent recovery dynamics in many countries. Meanwhile, from Brazil to India to Ethiopia the political winds favour business-friendly leaders who have prioritised economic development. To be sure, slower Chinese growth is a concern, but being selective in EM should bear some very juicy fruit.
A familiar maxim of British politics (coined by the classical scholar and firebrand Tory MP Enoch Powell, whose own experience was a case in point) is that all political careers end in failure. However, few have ended as unceremoniously as that of Theresa May, who this morning announced her plan to resign as Prime Minister on 7 June after a bruising cabinet revolt this week. In the period since she came to power in the wake of the 2016 EU referendum, it is hard to identify any noteworthy personal or policy victories. Her principal task – to take the UK out of the EU – was a difficult one given its inherent complexity, the deep ideological divisions within and between political parties on what Brexit (if any) to pursue, and the Tory’s wafer-thin majority in Parliament. To make matters worse the PM had supported Remain in the EU referendum campaign, which lead to an absurd set of circumstances where the government was forced to come up with a policy which it did not believe in. A recent poll suggested that 55% of UK voters felt sympathy for the PM in the past year. But when a leader seems only to evoke either derision or pity, you know they are doomed. Moreover, when you consider the litany of mistakes that she made – from squandering her Parliamentary majority by calling an unnecessary general election in 2017 to setting the priorities that the Civil Servants who led the negotiations turned into a politically impassable deal – it is hard to conclude that the PM is just a blameless victim who was dealt an impossible hand. If politics is an art, the Withdrawal Agreement she negotiated is a far stretch from a Monet. Still, looking forward, what does her departure mean for British politics – and Brexit? Most likely to succeed her is Boris Johnson, the Brexiteer Tory MP who led the Leave campaign in 2016. His election would increase the prospect of a ‘no deal’ Brexit, particularly if the EU refuses to rewrite the Withdrawal Agreement as it has so far. Johnson would almost certainly favour a more arms-length relationship with the EU, so the Political Declaration looks set to change either way. Other runners and riders for the leadership probably have one chance to stop Johnson winning: they need to find plausible alternatives with more support in Parliament because only the two with the most votes from MPs will be put to the Tory membership, who favour BoJo. We suspect Boris Johnson will win, especially with the Brexit Party threatening to destroy the Conservatives electorally if a true believer Brexiteer does not take to the helm. Although, maybe he will be stabbed in the back at the last minute. Déjà vu, anyone?
At the risk of sounding like a broken record, recent developments in the UK are a good example of why we continue to favour USD over GBP: the UK economy is fundamentally strong, and the pound is cheap on a PPP basis, but UK politics is far too unstable and unpredictable. Looking ahead, the pound could well weaken further towards its post-referendum lows as the probability of a ‘no deal’ Brexit increases with Theresa May’s departure. Markets are not too keen on the prospect of a Prime Minister Johnson, given his sanguine attitude towards an abrupt UK departure from the EU. And the EU will be sure not to give BoJo an easy ride in negotiations if he makes it to Brussels as UK PM.
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