Market Viewpoints

Summary

Society is a three-legged stool where each leg – economic, political and social – has to hold for the stool to stay upright. We often spend too much time and too many resources analysing and reporting on the economic and political legs, forgetting that the social leg is just as important, if not more so. Unaddressed, or wrongly addressed, social concerns have a tendency to creep up quietly and overwhelm societies – Brexit, Trump and the populist movement sweeping across Europe are good examples of this. German Chancellor Angela Merkel is finally in political trouble, not for economic mismanagement, but for her immigration policies. How fast the tide turns! When Merkel opened Germany’s borders to thousands of asylum seekers three summers ago, people in the affluent state of Bavaria rushed to help in such great numbers that authorities had to briefly turn back offers of clothing and food. It’s the same Bavaria now that has become Merkel’s Waterloo. The Christian Democrat Union (CDU) and the Christian Social Union (CSU) have formed a common group in the German Bundestag since 1949. However, this 70-year partnership that has provided leadership to the Eurozone over last two decades, is now at a breaking point. For the European Union (EU) and the Eurozone, the only thing worse than a strong Germany is a weak Germany. With the exit of Merkel, the EU would be robbed of the only political leader who appears to have the stature and experience to hold the bloc together, as it stumbles from one crisis to the next.

It’s NOT the Economy, stupid:

Ever since US President Bill Clinton’s victory in the 1992 election, Clinton adviser James Carville’s battle cry – “It’s the economy, stupid” has been a truism in politics and it has become part of the global lexicon. In the time since, few have contested the belief that, except for national emergencies such as war, famine or epidemics, no policy or issue mattered more than the economy, as measured by – jobs and growth.

Or at least so we thought…until two years ago when Brexit and Trump happened and we quickly learned that this phrase didn’t hold water anymore. If one looks at the International Monetary Fund (IMF) data for 2016 – the year Brexit and Trump happened, the US and the UK recorded the best GDP growth among the G7 nations and were experiencing one of the lowest levels of unemployment in their history.

Society is a three-legged stool where each leg – economic, political and social – has to hold for the stool to stay upright. We often spend too much time and too many resources analysing and reporting on the economic and the party politic legs, forgetting that the social leg is just as important, if not more so. Unaddressed or wrongly addressed, social concerns have a tendency to creep up quietly and overwhelm societies. In Italy, the populist combination of the 5 Star Movement (M5S) and the League have now increased their share of the vote to 60%. The populists in Sweden are now tied for the lead and poll at about 20% (that’s nearly four times the 5.7% which saw them enter Parliament for the first time in 2010) and in Germany Chancellor Angela Merkel is finally in political trouble, not for economic mismanagement, but for her immigration policies.

The unemployment rate in Germany is at a 40 year low, the trade surplus at a record high and, last year, Germany, experienced its best GDP growth in a decade. Yet, Merkel has to contend with reading her political obituaries in the press and is on the brink of being toppled because of her policies on immigration. The arrival of over 1.4 million asylum seekers in Germany over the last three years has stoked social issues – fears of demographic change, anxiety over reports of crimes committed by the migrants and the costs involved in managing the migrant crisis which is estimated to cost Germany over €20 billion a year. How fast the tide turns! When Merkel opened Germany’s borders to thousands of asylum seekers three summers ago, people in the affluent state of Bavaria rushed to help in such great numbers that authorities had to briefly turn back offers of clothing and food. It’s the same Bavaria now that has become Merkel’s Waterloo.

Horst Seehofer the head of the Christian Social Union (CSU), the Bavarian sister party and coalition partner of Merkel’s Christian Democrat Union (CDU) has fallen out with Merkel over her handling immigration. Seehofer wants to turn away certain migrants from the German borders and put a lid on immigration. Merkel is opposed to this policy and sees any unilateral action by Germany making the migrant crisis worse, as no other state is prepared to accept migrants returned by Germany.

Data from the German federal labour agency, as reported by the Wall Street Journal indicated that by the end of 2017, some 84% of the 700,000 Syrians currently in Germany were living on benefits and more than a quarter of the six million recipients of the basic form of income support—which comprises free rent, heating, legal representation and a monthly cash allowance for food and other essentials—were non-European (EU) migrants. A Kantar Public poll published June 23 showed that 61% of Germans supported the CSU’s proposal to tighten the border regime and 57% wanted to slow down immigration because they were worried about integration. The migrant crisis is roiling Europe, as Italy and France trade insults over the handling of boats carrying migrants and the four Eastern European “Visegrad” counties – the Czech Republic, Hungary, Poland and Slovakia – are boycotting the European Union (EU) summit to discuss a unified response to the migration crisis.

The CDU and the CSU in Germany have always formed a common group in the German Bundestag since 1949. However, this 70-year partnership that has provided leadership to the Eurozone over last two decades is now at a breaking point. The relationship has now become so untenable that Seehofer told one German newspaper recently that he “can’t work with that woman [Merkel] anymore.”

So, what’s at risk if Merkel is ousted?

For the EU and the Eurozone, the only thing worse than a strong Germany is a weak Germany. Serious decisions remain to be made on the future of Eurozone: Migration, defence, the European Monetary Fund and other issues – let alone negotiating Britain’s exit from the EU and that sword of Damocles – Trump’s tariffs – that hang over EU car exports. With the exit of Merkel, the EU would be robbed of the only political leader who appears to have the stature and experience to hold the bloc together as it stumbles from one crisis to the next. The EU could drift untethered and directionless with severe social consequences for the continent.

At an informal meeting last week, Merkel failed to persuade her EU counterparts on an EU-wide asylum policy for migrants. She now has the EU leaders summit this week as the last chance to get a deal to take over to Seehofer. The CSU has set a July 1 deadline for Merkel to comply with its demand. The stage is therefore set for a decision on the fate of Merkel on July 2, or shortly thereafter.

Markets & the Economy

As I anticipated in the May newsletter, the US Federal Reserve (Fed) increased interest rates by +0.25% at its June meeting, taking rates from +1.75% to +2%. The Federal Open Market Committee (FOMC) also released its quarterly “dot plot,” that shows where Fed members expect rates to go over the next few years. The median member predicts rates will be between +2.25% and+ 2.5% by the end of 2018 i.e. two more hikes this year. Fed Chair Jerome Powell remarked – “The economy is doing very well. Most people who want to find jobs are finding them. Unemployment and inflation are low.” The US unemployment rate has edged down to +3.8% and is on target to hit a 50 year low of +3.4% by next year.

However, in Europe, the Bank of England (BoE) at its June meeting held its benchmark interest rate steady at +0.5% and while the European Central Bank (ECB) at its June meeting signalled an end to its bond program, it also indicated that monetary policy will continue to be loose at least for another year, with a rate rise unlikely over next 12 months. The growth in the Eurozone economy appears to have slowed sharply in the first six months of this year and the Eurozone now looks set to grow at half the pace of the US. In Germany, which accounts for about a third of Eurozone GDP, the key business climate indicator recorded its sixth drop in seven months amid mounting concerns over trade tariffs and their consequences on German automakers and other exporter.

Citigroup’s Economic Surprise Index (chart above), a widely followed indicator of how the data are performing relative to expectations shows that the US continues to be the best economy, with the pace of positive surprises and better than other regions of the world. Outside of the US (CESIUSD), economic surprises have been firmly negative. The pace of economic surprises in China (CESICNY), Emerging Markets (CESIEM), Europe (CESIEUR), Japan (CESIJPY), and the United Kingdom (CESIGBP) are all almost at their most negative levels in at least a year.

The equity market’s performance year-to-date reflects a growing divergence in the global economy and its exposure to trade. The vulnerability of Europe and China to trade tariffs comes from the fact that goods and services exports, make up 27% of the Eurozone’s GDP, 21% of China’s, but just 12% of US GDP.

On a year-to-date basis the S&P 500 (SPX) is up +1.6%, the EURO STOXX 50 index is down -2.6 %, China’s Shanghai market (SHCOMP) -14.0%, the MSCI Emerging Index -10.0%, Japan’s Nikkei -2.0% and THE Swiss market (SMI) -8.5%. Among the sectors that have performed well this year the runaway leaders are Technology (XLK, +9.4%) and consumer Discretionary (XLY, +11.1%). This has kept the SPX positive for the year.

Fears of a “trade war” will remain fodder for headlines but the SPX should withstand this thanks to a healthy earnings backdrop. Bottom-up estimates put the 2019 and 2020 consensus earnings-per-share (EPS) at $175 and $193 for 2019 and 2020 respectively. A 16x multiple on $175 puts the SPX at the 2800 level. Over the last four months and particularly since the market sell-off in February this year the SPX has been trading in a range of 2550 and 2800. While the top end 2800 is proving stubborn to breach, it is more likely the SPX will stay at the top end than the bottom end of this range from here until the end of the year. Q3 earnings start in two weeks’ time, and that may lift the bottom range to 2700 for good, thereby opening SPX moves to the upside.

Markets & the Economy

The big risk of a trade war is inflation. Trade wars represent a shock to the supply side of the economy. For the past 20 years, China has generally exerted a broad deflationary pressure on prices of most items and kept prices low. It is for this reason that the cumulative change in US clothing prices (excluding footwear) from January 1990 to the end of last year was zero (see chart above).

Imagine if, as a result of trade war, trade is reduced or outright collapses. The supplies cannot be replaced overnight and there’s bound to be a spike in inflation, which would get the Fed racing to raise rates and the equity market would collapse.

The US economy is on a very good footing. I, therefore, continue to hold US overweight position in equities with a bias to Technology (XLK), Healthcare (XLV), Financials (XLF) and Consumer Discretionary (XLY). I stay underweight Europe as I have been writing for a few months now. The sell-off in Emerging Markets, has opened up good levels to go long but it is best to wait for a few more weeks before going long. The 25% tariff on China’s $50bn exports to the US comes into effect on July 6

In terms of stocks I like: JP Morgan (JPM US), Bank of America (BAC US), Citi (C US), VISA (V US), Blackrock (BLK US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), Amazon(AMZN UW), Alibaba (BABA US), Baidu (BIDU US), JD.com (JD US), Salesforce (CRM US), Home Depot (HD UN), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Vinci (DG FP), Pepsi (PEP US), LVMH (MC FP), General Electric (GE US), Activision Blizzard (ATVI US), Micron Technology (MU US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US)

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital