Bedrock’s Newsletter for Friday 21st of June 2019
21 June 2019


 Friday, 21st of June 2019

“Politics is the art of the possible, the attainable — the art of the next best”

― Otto von Bismarck



Markets continued to recover this week, boosted by dovish Central Banks on both sides of the Atlantic and some tentative signs that Trump and Xi are willing to negotiate on trade once more. The drawdown in May shaved close to 7% off the S&P 500 Index, but the subsequent rally has almost closed the gap. Investors were surprised and disappointed by the collapse of US-China trade negotiations last month, and the repricing that followed was driven by this negative shift in sentiment. However, the Fed and the ECB have since reassured markets that all the liquidity they need to avoid another sell-off like that in Q4 2018 will be made available if the US-China Trade War deepens (or catches Europe in its web) and the economic data turns south. ECB President Mario Draghi was first out of the gate in early June when he revised the Bank’s forward guidance and ruled out any rate hikes before mid-2020. On Tuesday this week he doubled down on this dovish tilt, defending the ECB’s extraordinary stimulus measures and hinting at further easing if reflationary forces do not take hold in Europe soon. Meanwhile, in a statement after the FOMC meeting on Wednesday (and not wanting to be outdone) Fed Chair Jerome Powell cited rising ‘uncertainties’ as sufficient reason to abandon the Bank’s previous commitment to more rate hikes this year. The Fed will no longer merely be ‘patient’ before pressing ahead with normalisation. Instead, it will ‘act as appropriate to sustain the expansion’. Although Powell stopped short of cutting rates outright, a move that futures prices implied had a 20% probability before his statement, the Fed has made clear its intention to support markets and the US economy through any future turbulence. The tightening bias that coloured its decision-making to date has been abandoned, and the market has rallied sharply in response. Immediately following Powell’s statement, the US 10Y Treasury yield dipped below 2%, hitting a 21-month low, while bond yields in Europe and elsewhere (already down markedly after Draghi’s announcement) fell further. At one point, even the French 10Y turned negative. Finally, and to cap off a week full of central bank interventions, the Bank of England decided to cut the country’s growth outlook on Thursday and to keep rates on hold as inflation hovered around target. The UK has seen a raft of weak data since the original Brexit deadline passed in March as companies that had stockpiled in advance of a possible ‘no deal’ exit in the spring have sold off their superfluous inventory. This GDP hit should be temporary, but with a new Brexit date just around the corner the Bank does not want to spook the market just as others adopt a more cautious tone. (Ride this wave.)

In addition to the dovish central bank guidance last week, markets were also buoyed by the news that Presidents Trump and Xi are planning to meet on the side-lines of the G20 Summit in Japan at the end of the month in order to discuss the impasse in US-China trade talks. Senior US and Chinese officials are currently laying the necessary groundwork, so that the two Presidents can restart negotiations. China and the US remain poles apart on a number of critical issues, from industrial subsidies to forced technology transfers and enforcement of the deal once signed. Moreover, both sides accuse the other of backtracking on commitments made at earlier stages of the talks and thus for their breakdown. Nevertheless, the blame game may now have played out and diplomacy could take its place with detail added to the skeleton agreement that the US and China nearly struck in May. It goes without saying that a comprehensive trade deal is in both countries’ commercial interests, but in the broader strategic setting the terms, timing and tone matter hugely. If negotiations get rebooted, expect plenty of upside.

In other geopolitical news, tensions escalated sharply in the Persian Gulf on Thursday after Iran shot down a US reconnaissance drone over international waters in the Strait of Hormuz (according to the US, at least). The world has since been holding its breath, awaiting the US response, with crude oil trading up 5% in two days as the threat of conflict built. In the event, President Trump ordered limited airstrikes on Iranian missile batteries and other military targets on the Gulf coast, before calling off the barrage at the last minute. A fortnight ago, we spoke at length about the crisis in US-Iranian relations, as well as about potential catalysts for a military confrontation in the Gulf (and the Strait of Hormuz in particular) and the high-stakes Iranian escalation strategy of which this attack looks so much to be a part. Iran seems to be testing US resolve to assess their likely response to breaching enrichment limits and, so far, Trump has bottled his response. (The ultra-hawkish National Security Advisor John Bolton must be in a straitjacket somewhere far from the President’s ear for Iran to have got away so lightly.) The President is instinctively an isolationist who made a promise to voters to avoid war in the Middle East at all costs. However, he also tore up the JCPOA (i.e., the Iran nuclear deal) when the only way to get a better deal was to convince Iran that regime change would be the inevitable price of seeking a nuclear weapon in earnest. The crisis is not yet over, and a barrage of missiles may yet follow, but the President is currently sending mixed messages to Tehran about what behaviour the US will stand for: this is dangerous when escalation is the only way Iran can build leverage ahead of talks and should be seen as a negative signal for markets over the medium-term (even if no action offers investors a short-term respite). Moreover, other potential adversaries from North Korea to China can surely rest easier in the knowledge that the US President’s bark is worse than his bite…

Another political battle that is well underway is over the future of the UK Conservative Party – and thus Brexit. Prime Minister Theresa May was unceremoniously forced to resign on 7 June, having failed to deliver the Brexit deal she spent two painful years negotiating with the EU. Today, she remains in office (until a successor is found) but no longer in power. Instead, all eyes are on the Tory leadership race, where the candidates have been progressively whittled down by successive MP votes until just two remained late on Thursday evening. These two individuals – Boris Johnson and Jeremy Hunt – will now be put forward to the party membership in a postal ballot with the results expected at the end of July. Boris Johnson has been the favourite from the start and, although the Tory Party has a history of political upsets in leadership elections, we maintain that he is likely to win any vote with the membership given the polarisation of the party as well as its Euroscepticism and the sense of national crisis. If he does, the probability of a ‘no deal’ departure at the end of October is the most likely outcome; that is, unless the EU agree to time-limit or replace the so-called Irish backstop, which they have so far refused to do. Much has been made of Parliament’s ability to block a ‘no deal’ Brexit, but it takes two to tango and a UK government which refuses to back down (or which cannot get the Withdrawal Agreement through Parliament) won’t be granted an extension by the EU for fear of a rolling ‘cliff edge’ and the paralysing uncertainty of Brexit delayed. This autumn we will finally find out whose red lines are more pink than crimson and what deal if any there is to do between the UK and the EU before Brexit.