Market Viewpoints

Summary

I can understand why the Brexiteers are opposed to the UK’s Chequers proposal, but I do not understand the European Union’s opposition to it. The Chequers deal would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations, if the UK were not seen as having control of domestic rules or laws or being a credible negotiating partner. In my opinion, the EU, in pushing the envelope and rejecting the deal, has miscalculated. The Chequers deal is better for the EU than a “no-deal” or any other deal frankly. UK Prime Minister Teresa May will now do well to turn this rejection of her proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. Despite the antics and acrimony, I do see the UK and the EU concluding a deal, and it will likely be before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on Word Trade Organisation guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU.

Chequers chucked, so what next?

That there was no deal on the UK’s Chequers proposal at the European Union (EU) Summit in Salzburg last week, shouldn’t have come as a surprise to anyone. The half in/half out deal that this proposal called for, was opposed both within the UK and in Brussels – with only Prime Minister Theresa May pushing for it. The Chequers proposal would provide the UK access to the EU “single market” on goods after Brexit, while services would be governed under different rules. In return, the UK would accept the EU’s “common rulebook” – standards governing manufactured and agricultural products.

Leading Brexiteer Boris Johnson described this proposal as a “suicide vest” for the British constitution. The European Research Group (ERG), a grouping of Tory Eurosceptic Members of Parliament (MPs), who number close to 80, had warned that they would vote against the Chequers plan in Parliament. Brexiteers were opposed to the Chequers proposal as it would hamstring the UK, make it an EU rule-taker and keep the UK in the “single market.” There would be no realistic prospect of the UK reaching trade agreements with other nations if the UK were not seen as having control of domestic rules and laws or being a credible negotiating partner. Michel Barnier, the Chief EU negotiator on Brexit was opposed to the Chequers proposal too. Barnier remarked “les propositions sonts mortes (the proposals are dead).”

I can understand why the Brexiteers are opposed to the Chequers proposal, but I do not understand the EU’s opposition to it. In my opinion, the EU, in pushing the envelope, has miscalculated. The Chequers deal is better for the EU than a ”no-deal” or any other deal frankly. The Chequers deal would have essentially kept the UK in the single market for goods (where the EU has a trade surplus of +£100 billion with the UK) and would have kept the UK out of the single market for services (where the EU has a deficit of -£28 billion). The EU would thus continue to sell goods and keep its huge surplus in goods intact. But the EU doesn’t do economics, it does ideology. Ideologically, Brussels saw the Chequers proposal as breaking up the “single market.” In their opinion, enjoying the benefits of the single market (albeit only in goods) without free movement of people would make Brexit look easy. Brussels worried that more copycat departures could follow and the EU would eventually collapse. I disagree with this thinking entirely.

“In my opinion, the EU, in pushing the envelope have miscalculated. The Chequers deal is better for the EU than a no-deal or any other deal.”

‎Just because the UK is leaving the EU and can make a success of it, it doesn’t mean that others will follow suit. If leaving and making a success of it were so easy then Greece and Italy would have left the EU long ago, reclaimed their currencies back and embarked on efforts to reduce crippling debt and rebuilt their economies. It has taken the UK over a decade to organise an “in-out” referendum since it was first mentioned in 2007. It will take a good few years for the UK to chart a path independent of the EU despite the UK having an independent monetary policy and several opt-outs in its current EU membership. Leaving is one thing and making a success of it is quite another. Out of the twenty-eight EU nations, eighteen are net recipients of EU funds, so they are not going to leave the “free money” anytime soon. Of the ten who are the net contributors Germany, the UK, France and Italy contribute the most, and are candidates to leave in a theoretical discussion. However, Germany is the biggest beneficiary of EU project so it won’t leave (until the cost of keeping the EU together outweighs its benefits). France punches above its weight and the EU helps it do it, so they wouldn’t leave either. Italy with over €2.3 trillion of debt and moribund GDP growth has much to ponder before they can consider leaving the EU and the Euro.

The divide between the EU and the UK is one of history and beliefs. It’s about Catholicism vs. Protestantism as political scientists Brent Nelsen and James Guth describe in their book, “Religion and the Struggle for European Union.” Broadly speaking they suggest, Catholics favour the EU more than Protestants. These attitudes were forged in the Reformation that took place in 16th Century Europe. It led to the development of two different approaches to governance in Europe. Catholics see Europe as a single cultural whole that ought to be governed in some coordinated way. Protestants, on the other hand, see the nation state as a bulwark against Catholic hegemony and a guarantor of individual liberty. On the Continent, people are used to the State/supranational bodies running the country. Brussels taking over ”governing” in the 20th Century is no different than Imperial France or the Austro-Hungarian Empire that ran Europe in the 18th and the 19th Centuries. It’s a continuation of history. If you suggest this to Europeans, they may not see it this way. They will tell you that Europe has come far, but the reality is they haven’t come that far and history is not on their side. Their acceptance of the EU is far deeper and not based on reason but a habit. A habit formed over many centuries.

So where do we go from here?

PM May will now do well to turn this rejection of her Chequers proposal into an opportunity and make a clean Brexit because that’s what Brexit means – the parting of ways and not a half-way house between the UK and the EU. It’s time to move on to a “Canada +” deal. At its most basic, a Canada-style deal, is the UK striking a free trade deal with the EU after Brexit along the lines of the agreement the EU recently signed with Canada. This would remove most, if not all, customs tariffs on goods sold between the EU and the UK and potentially allow some market access for services.

So, will the EU accept it readily? Not really. In the EU’s infinite wisdom, this solution would not solve the problem of the Irish border. Brussels fears that Ireland could become a backdoor into the EU market for goods from around the world that may not comply with EU’s standards and tariffs. So, for a Canada-style deal to happen, the UK would have to give assurances on regulations and standards the EU holds dear. If the EU is not assured, it would effectively put a customs and regulatory border in the Irish Sea, something that is unacceptable to PM May. The backers of a Canada-style deal reject the EU’s reservations about it and have long maintained that with the use of technology it would be possible to ensure that goods crossing between Northern Ireland and the Republic fulfil customs requirements without the need for physical infrastructure at the border. The EU physically checks only around 3% of imports, the rest is done electronically and with mutual recognition of standards. So, it is not a big problem to do the same with the Northern Ireland- Republic of Ireland border.

“An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching”

As I have said in the past, despite the antics and acrimony, I do see the UK and the EU concluding a deal most likely before year end. Now it is also possible that there might not be a big bargain deal to be had, in which case you will see a series of sector-by-sector deals to minimise disruption and some sectors may trade on WTO guidelines in the immediate aftermath of Brexit before concluding a final deal. The modern world has complex supply chains, and the UK and the EU particularly so, given their close history and trade over the last 50 years. Getting a deal and minimising disruption is a priority both for the UK and the EU. It remains an issue of mutual recognition of standards. Besides Brexit is not merely a matter of economics. The UK may be leaving the EU, but it is not leaving the US-led Western alliance. The UK’s role is key to sustaining US support for Europe and the guardian of peace in Europe – the North Atlantic Treaty Organisation (NATO) that US President Donald Trump has threatened to withdraw from. An intransigent EU will be playing into the hands of those in the Trump administration who want to break the EU and reduce US funding for NATO. The consequences of a No Deal will be far-reaching. This is well understood in Brussels.

As for the fantasy of a second referendum, unless the EU is willing to move to a multispeed EU with consent as the basis of an ever-closer union (i.e. Europe a la carte), there is no point in offering another referendum. It will result in the same outcome. An EU which hasn’t bothered to get its treaty ratified by member states (because it can’t be sure of the outcome) and ignored the result of previous referendums in member states, is galaxies away from a Europe a la carte. Those seeking a second referendum are wasting their and everyone’s valuable time. They are well advised to offer their time, money and services to charitable work. ‎

Markets & Economy

As expected the US Federal Reserve (Fed) raised interest rates by +0.25% Wednesday, as it continues to gradually roll back its policies of easy-money. This lifts the Federal-Funds Rate to between +2% and +2.25%. The increase, is the third this year and the eighth since the Fed began to raise rates in late 2015. For the first time since 2008 the benchmark rate is above 2% and also above inflation, measured by the Fed’s preferred gauge, Personal Consumption Expenditures (PCE) which excludes the volatile energy and food categories. The so-called core PCE index rose +2% in July. Fed Chairman Jerome Powell remarked, “This gradual return to normal is helping to sustain this strong economy for the longer-run benefit of all Americans.” Trump, in a press conference later said he was “not happy” about the Fed raising rates. He however added, “They are raising them because we are doing so well” and that higher rates weren’t all bad because they could help Americans who rely on interest savings for income.

Between this rate increase and the Trump tax increase, I mean the Trump tariffs, the US economy risks slowing down. How soon that happens will depend on the level of tariffs implemented and how quickly the Fed continues to raise rates. The Fed hinted it will raise rates one more time this year and by one percentage point through next year. If Trump raises tariffs to 25% and they stay there, and the Fed Funds Rate goes up to 3% or more, then recession fears will increase. For now, I have no such fears.

While the China-US trade war has dominated the narrative over the last quarter, rising oil prices are now getting everyone talking. Impending sanctions on Iran have lifted crude prices. Trump has called for the Organization of the Petroleum Exporting Countries (OPEC) to increase the oil supply and stop “ripping off the rest of the world” by pushing oil prices higher. However, at its meeting in Algiers on Sunday, OPEC and Russia reiterated that they want to adhere to current production quotas first implemented at the start of 2017. If the glut of oversupply goes, demand continues to increase and US oil inventories fall – then US sanctions on Iran and a Trump defiant OPEC spell higher oil prices. Brent could easily get to $90 and over in the short term.

Source: Bloomberg

Regular readers of this newsletter will know that I have been bullish on US equities and overweight US equities for a long time now and even during all of this year, despite the market talk of recession and an impending market correction. The S&P 500 index (SPX) has not disappointed and continues to pass the “back to school” test as we enter autumn after a volatile summer. The SPX broke out to a new high (chart above) at the end of August and pulled back in early September. Crucially the pullback found support right at its prior highs from January. After holding that level, the SPX has continued to trade higher. If you are a chartist, it doesn’t get much more textbook than this. With the US economy growing at over +3.5%, no signs of a recession on the horizon and a measured escalation of the US-China trade war, the SPX has legs to continue reaching new highs. Besides, many investors and commentators are still sceptical about the SPX rally and that’s a good thing. You should worry when everyone is bullish.

While the SPX index has recovered nicely from a pullback early this month and is up +9% Year-To-Date (YTD), Europe’s flagship Euro Stoxx 50 (SX5E) Index has slipped down further, -2.3% YTD, and so has the MSCI Emerging Market Index, -10% YTD (table below). The SX5E could have been worse off had we not seen a rally in European stock (particularly financials) on the back of reducing confrontation between Italy and the EU over the Italian budget. The Italian government officials from both parties – 5 Star Movement and the League – have pledged to respect EU rules limiting deficits, after a squabble to break EU rules on fiscal discipline led to heavy selloffs of Italian bonds over the summer.

The prospect of a quick resolution to the US-China trade war has dimmed. Trade tensions between the US and China will be a drawn-out affair as this is more than a trade spat. It’s about global influence and leadership. Jack Ma, Alibaba’s Executive Chairman rightly remarked – “It’s going to last long, it’s going to be a mess. Maybe 20 years.” Early this week China cancelled trade talks set for this month and the US imposed 10% tariffs on $200 billion of Chinese exports to the US. China responded with tariffs on $60 billion of US exports to China. This is likely to beget US tariffs on the remaining $267 billion of Chinese exports to the US i.e. just about all imports from China would face a tariff going forward.

The war of words will continue and as Winston Churchill and Harold Macmillan used to say “Better jaw-jaw than war-war.” I think the world and markets can endure a war of words, however long this takes. The US is the declining power and China is the rising power, but there needn’t be a war. The sensible thing for the US to do would be to agree on a deal with China and open China’s market to US products. China is shifting its economy from being the world’s largest exporter to the world’s largest consumer. Speaking at the World Economic Forum (WEF) early this year Chinese President Xi Jinping remarked that over the coming five years, China would import $8 trillion of goods. US companies want in on this. Trump may have his own ideas but he is not an ideologue. You can see that from the exemptions granted to a range of products (particularly Apple’s products) in the latest round of tariffs imposed by the US. US businesses and indeed European businesses are not ready to forfeit this opportunity of China trade – an emerging Chinese middle class of 300 million people with average income growing at almost double digits. The US will have to learn to live with reduced influence as China rises until such time as China has its own political troubles. The US doesn’t have to worry about any other power eclipsing it. A declining and bureaucratic Europe will never be much of a challenge to the US and Russia may be a military power but it will never be an economic power given the paranoia and mistrust that grip the nation and its leadership.

Having said that, the EU’s announcement this Tuesday that it would establish a special payments channel to maintain economic ties with Iran is significant and it may be a first step to challenging the supremacy of the US Dollar. Should America be worried? Not so fast. Can American counter the threat? Absolutely. You can do business with Iran or you can do business with the US, but not both. The risk of losing access to the $20 trillion US economy and being cut off from the Western financial system can sober any business and the next time the ECB comes to the US Federal Reserve window to arrange Dollar swap lines, you can be sure what the response will be. European banks will be foolish to provide payment options to companies seeking to do business with Iran. It will be like picking up pennies in front of the steamroller. The US Dollar will meet its challenge but this is not the moment.
After having a bad first half of the year, Q3 has been extremely good for the Healthcare, Industrials and Financial sector stocks. As the table below indicates, almost all of the year-to-date performance for Healthcare stocks has come in Q3. This good performance is set to continue. Healthcare stocks are seen as safety stocks and as the rally gets old, defensive sectors – Healthcare, Consumer Staples, and Utilities will see increased inflows. Again, as I have said above, I do not see a US recession on the horizon and an inflation surprise to the upside also looks distant.

I continue to be overweight US stocks with sector preferences for Technology (XLK), Financials (XLF), Healthcare (XLV) and Industrials (XLI). I remain underweight Europe and underweight Emerging Markets.

In terms of stocks I like : VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Gilead Sciences (GILD US), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IMB US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Netflix (NFLX US), Twitter (TWTR US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US)

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital