Friday, 10th of October 2019
“We have no eternal allies, and we have no perpetual enemies. Our interests are eternal and perpetual, and those interests it is our duty to follow.”
– Viscount Palmerston
After a choppy start to the week, stock markets were buoyed by encouraging statements on Brexit and US-China trade talks in the second half. Over the weekend, Brussels had announced that UK PM Boris Johnson’s plan to replace the so-called Irish backstop “does not provide the basis for agreement” and cancelled a meeting of EU leaders where they were planning to discuss a new Brexit deal. A supposedly frosty telephone conversation between the UK Prime Minister and German Chancellor on Tuesday then seemed to confirm that the Brexit talks were on the verge of collapse and the UK was headed for ‘no deal’, or at least another extension. Indeed, a UK government source briefed The Spectator magazine that Merkel had demanded that Northern Ireland always remain within the EU customs union, making a deal “essentially impossible, not just now but ever”. Sterling took a dive and EU Council President Donald Tusk publicly accused Johnson of playing a ‘stupid blame game’ and not wanting a deal at all. The bust up seemed to put any hope of a deal before the end of October well out of reach, with the two sides still poles apart on how to minimise friction at the Irish border should future trade talks between the UK and EU break down. However, after the UK PM met his Irish counterpart for a country jaunt at a handsome wedding venue in North West England on Thursday, Brexit seemed to be back on track. In their subsequent joint statement, the two parties declared that “they could see a pathway to a possible deal” after a “constructive discussion” focused on the “challenges of customs and consent”. No details of what may have been promised by either side have been leaked to the media ahead of talks between UK and EU negotiators today. But the markets have interpreted the change in tone as a change in the substance too. We are hopeful but remain cautious. At this late stage in the Brexit process, neither side wants to appear unwilling to negotiate in order to avoid blame for a possible ‘no deal’ Brexit, and the statements attributed to the German Chancellor had the EU on the backfoot in this regard. The decision to restart talks could thus be all about managing voter perceptions and not about serious engagement, with one side (or both) playing for time or acting disingenuously for political reasons. Either way, we will soon find out if a deal is possible before the 31st October deadline. If so, the move higher in Sterling that we have seen in recent days is only the beginning. The pound was above 1.40 against the dollar when the UK and EU seemed likely to reach a Brexit agreement in 2018 and it could return to those levels (having fallen to ~1.21 at the end of August). UK equities too should do well in such a scenario given that price multiples and domestic economic fundamentals look attractive relative to most other European developed markets. But the risk of ‘no deal’ keeps us out of the market for now.
In an abrupt change to the mood music playing on Monday morning – when the US decided to blacklist two dozen Chinese organizations and firms over human rights abuses in Xinjiang – from Wednesday onwards there were a series of positive developments in the latest round of US-China trade talks taking place in Washington DC. New tariffs are set to be implemented on 15th October and, in an effort to avoid them, both the US and China have suggested that they are willing to do a limited trade deal. If struck, the interim agreement will likely provide some level of tariff relief for China (and perhaps an extended waiver for US companies to buy Huawei products) in exchange for a mix of increased purchases of US goods, basic IP reforms, and a pledge not to competitively devalue the renminbi by China. President Trump has agreed to meet the Chinese Vice Premier and Chief Trade Negotiator, Liu He, on Friday. This is widely seen as a signal that the talks are approaching a conclusion. The decision to countenance a ceasefire and an interim trade agreement is a significant change of heart for Donald Trump who has previously rejected calls for any deal that fails to include reform of China’s subsidies and other market-distorting industrial policies. However, the political and legal obstacles to a comprehensive US-China trade deal have been clear for some time and, as the impeachment battle weakens the US President at home, China has dug in its heels. For his part, the Donald now appears keen to have at least a small win on trade to sell to voters ahead of the 2020 election, saving the thorniest issues for the future (when he may not be President anyway). China is happy to oblige given the narrow scope of the deal and the pronounced slowdown that has affected the country since the trade war with Uncle Sam began. We expect that the two superpowers will likely strike a limited deal given the momentum behind the talks, but that many issues will be left unresolved. Equities could bounce as the threat of escalation recedes, but most of the tariffs will remain in place so the implications for global growth should not be oversold.
Going forward, markets are likely to remain choppy with multiple sources of risk for investors to contend with. Indeed, there are several regions other than China that could yet face a major trade battle with the US. Perhaps the most important is the EU, on which the US recently decided to raise tariffs after the WTO found in favour of Boeing in a dispute with Airbus over illegal French subsidies. Should the block retaliate this could well ignite a trade war. Given the dire economic straits in which the Eurozone finds itself (and with Brexit still unresolved), this could send a jolt through European equity markets even with the ECB pumping money into the system. In the US, the rise of Elizabeth Warren as a contender for President in 2020 is another risk for markets. Her populist policy pronouncements have got many on Wall Street worried that, from the tech sector to healthcare, a much more interventionist (and no less protectionist) economic policy is imminent should Trump lose next year’s election. Thus, despite the apparent progress in US-China trade talks, we are very happy to have protection in place as we look beyond this quarterly earnings season.
The final subject for this week’s newsletter is the Middle East, where events in Syria and the Red Sea risk engulfing the region in conflict once more. On Monday, the US President unexpectedly decided to withdraw US special forces from the Turkey-Syria border after the Turkish President, Recep Erdogan, appears to have told him that Turkey would strike against Kurdish forces in the region. Turkey has been unsettled by the presence of YPG fighters (linked to the banned PKK who have fought a secessionist insurgency in Eastern Turkey for decades) among the Syrian Democratic Forces (SDF) presence in Northeast Syria. Without US support there is little doubt that the SDF will soon be pushed out of the 30-mile exclusion zone that the Turkish military aim to create. However, there has been heavy fighting since the invasion began on Wednesday and there is a risk that the thousands of ISIS militants in camps and sleeper cells across the region will use the chaos to escape and/or regroup. Trump has received significant bipartisan criticism for abandoning his onetime allies, but the President appears undeterred. He believes that leaving the Middle East is what his voters want and next year he faces them at the ballot box. European countries have been scathing of Turkey. However, Erdogan has since threatened to unleash another wave of migrants to Europe if it receives undue criticism from the EU… Elsewhere in the Middle East, Saudi Arabia appears to have responded to the Iranian attack on its oil infrastructure last month by striking an Iranian tanker in the Red Sea. This somewhat token gesture (given the scale of the previous assault and if Saudi is indeed responsible) suggests that the Kingdom did not feel that it could rely on US support for a more dissuasive move. Iran has simply called the suspected missile strike a “terrorist attack” and not attributed it to Saudi Arabia (or anyone else). Oil has spiked on the news, but a response from Iran is unlikely to be imminent. The regime is likely to have concluded from these limited strikes that there is significant room to ratchet up tensions further in coming months than it has done already, before it can expect to pay a price. This raises the stakes further in the Middle East and makes a dangerous situation worse. Buy oil.