Bedrock’s Newsletter for Friday 25th of October, 2019
25 October 2019

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 Friday, 25th of October 2019

He does not always choose the best Who muses long.”

– Johann Wolfgang von Goethe

 

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Stock markets globally are in positive territory this week, as the US and China edge closer to an interim trade agreement. The comprehensive deal that was initially sought by Donald Trump has been replaced by a less ambitious target, including a ceasefire but not an end to the trade war. Bloomberg is reporting that the compromise would involve restoring Chinese purchases of US agricultural products to at least $20bn in year 1 (i.e., close to the level of purchases in 2017). This may then rise to $40-50bn as part of a final deal in which the US agrees to remove the remaining punitive tariffs. In exchange for agreeing to phase 1, China wants the US to abandon the tariff hikes planned for year-end and lift those that were implemented in September. Should these terms be agreed it would not signal the end of the US-China trade dispute. And, if reports prove true, then what is being discussed is a far cry from Trump’s sweeping promise to transform the Chinese economic model by hanging tough on trade. Any deal will be welcome news for investors, of course, given the risk of further tariffs being implemented in December, and we expect market sentiment to improve if one is struck. However, there is much less upside from a narrow trade agreement than from one with broader scope. The threat of escalation after the 2020 election will remain, while a comprehensive deal that promoted economic liberalisation in China would have been a boon to foreign capital. That said, you take what you can get with the Donald. The one wild card in all of this is the crisis in Hong Kong, where pro-democracy protests have become increasingly violent in recent months. Xi Jinping has warned protesters of “bodies smashed and bones ground to powder”, but he has left the HK authorities to police the demonstrations alone so far. The US VP Mike Pence has warned that a forceful intervention by China would scupper any hope of a trade deal, big or small, and we doubt that China wants to get more involved. Still, events do tend to have a momentum of their own.

 

Q3 earnings season is now well underway and is offering mixed signals about the health of US and European corporates amid the broad global growth slowdown. Although many companies have beat expectations, analyst estimates were never particularly generous: the consensus produced by FactSet forecast a -4.7% reduction in earnings for S&P 500 companies in Q3. If this estimate proves roughly accurate, then large US firms will have reported a third consecutive quarterly YoY decline in net profits in Q3, even as revenues are expected to grow +2.6%. This compression of profit margins is a concern and should temper market sentiment until the decline is halted. There have also been some high-profile technology sector misses in the last few days and weeks. The biggest casualty of the season so far has been Twitter. The stock was down -20% at the Thursday open after the company disappointed on Q3 revenues and earnings and cut guidance given problems with bugs in its advertising products. Amazon, the all-powerful slayer of Main Street, has also come unstuck, lowering guidance for Q4 and revealing a significant dip in third quarter earnings on Thursday evening. In more positive technology news, Tesla and its messianic CEO Elon Musk recorded a surprise $342m profit for the quarter, prompting a +20% jump in the stock price that knocked $1.5bn off hedge fund shorts in a single day. Beyond IT and on the other side of the Atlantic, the most interesting set of results came from Nokia. The Finnish telecoms operator was forced to halt its dividend and cut earnings guidance for Q4 amid fierce competition in the roll out of next-generation 5G networks. Nokia’s results are a blow to Western efforts to find a rival firm to Chinese telecoms giant Huawei. With state support, Huawei has developed the most advanced 5G network anywhere in the world (available at rock bottom prices) sparking fears from Western intelligence agencies about possible Chinese state control of critical communications infrastructure in the US and Europe. As earnings season progresses, we will get a better insight into the global economy as a whole. We will also see how and to what extent the escalation of US-China trade tensions this summer shaped business investments and fundamental outcomes. Most important of all, as forward-looking investors, we will also see what pockets of opportunity present themselves from a possible interim deal.

 

This week, the Bundesbank warned that Germany had almost certainly fallen into recession in Q3 as the Eurozone’s powerhouse shrank for the second consecutive quarter. In its monthly report, the central bank described the recession as merely being technical and argued that it did not signal “a clear, broad-based and sustained decline in economic management with underutilised capacity”. The finger of blame was pointed squarely at the export-oriented manufacturing businesses, particularly the auto majors, which have witnessed a sharp contraction amid soft export orders from China and elsewhere and with the risk of a ‘no deal’ Brexit hanging over production lines. The domestically-focused economy has not suffered the same fate, which suggests that resolutions on US-China trade and Brexit could be of major benefit to the headline German and broader Eurozone prints. That said, the Chinese slowdown is not wholly the product of the dispute with America; far from it. The credit boom that drove unsustainable growth rates in recent years cannot continue and de-leveraging will be headwind at best going forward, regardless of US tariff levels. Thus, caution is warranted when positioning in today’s market, even when progress seems to be made on core issues that have driven day-to-day volatility.

 

One such matter that we all very much hope is coming to a close is Brexit (at least phase 1). Last week, we described the new EU Withdrawal Agreement in depth, so you will be happy to hear that we will not be repeating the agonising detail of what was agreed. Instead, we believe that three votes are worth noting from the past 7 days. On Saturday, the UK Parliament forced the PM to seek an extension to Article 50 to prevent ‘no deal’ on 31 October. Then, on Tuesday, Parliament decided to support the so-called second reading of the Withdrawal Agreement Bill (WAB), but to reject the PM’s rapid timetable for legislative scrutiny. Overall, the votes suggest that there is a majority in Parliament for some version of Johnson’s deal (19 Labour MPs supported the WAB), maybe with some amendments written into the domestic legislation to prevent workers’ rights being eroded post-Brexit. However, MPs want time to scrutinise the agreement line-by-line and do not want Johnson to meet his 31 October Brexit deadline. In response, the government has paused the WAB to see how long an extension the EU grants. Should there be a long extension to 31 January 2020, Johnson worries that MPs will use the time to wreck the bill by bolting on a customs union or confirmatory referendum that he could never back. He therefore strongly favours a short extension to 15 November (also preferred by French President Macron) in order to pressure MPs into backing the deal. However, it appears that the EU is set on the longer option, and Johnson has therefore demanded a general election on 12 December with Parliament having until it is suspended for the campaign in early November to accept or reject his deal. Labour is split and stalling on whether to agree. But the pressure from party activists will build the longer the election offer stands and a poll before Christmas is now odds-on. Given the votes this week, we believe that the UK is likely to leave the EU with Johnson’s deal in the coming weeks or months. That said, there are no prophets when it comes to Brexit – as we are all well aware after three roller-coaster years.

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