Market Viewpoints

Summary

The “political declaration” that Prime Minister Theresa May has agreed with the European Union (EU) is very vague and has very few details about what the future relationship between the EU and the UK will be. The declaration doesn’t commit the EU to anything. It’s not a legal agreement, unlike the 525-page “Withdrawal agreement”‘ which includes guarantees that are legally binding including the £39 billion “divorce bill” the UK will pay the EU, albeit over several years. Besides, the biggest bone of contention in the agreement – the Irish backstop – still remains. I do not see it passing the UK Parliament in its current form and even if it does, I strongly believe the Tory party will split and a new election will see Labour come to power. There is many a Conservative party voter who would not vote for the Conservative party again, such is the level of opposition to May’s “Withdrawal agreement.” Now, of course, all this could be averted if the deal were amended and the Irish backstop is either removed or has a fixed period of validity. I expect US economic growth to slow down next year and therefore believe that the US Federal Reserve (Fed) will pause hiking interest rates. I expect the Fed to increase rates only twice next year. The G-20 summit will be held at the end of this month in Argentina. With US President Donald Trump pushing publicly for a trade deal with China and China loosening its Joint Venture requirements ahead of the meeting, signs are that both sides want to make progress on this issue at the summit. We could see a rally in risk assets if a deal comes to pass or even if the 25% tariffs that are to come into effect in January are postponed. By the end of Q2, the US would have entered the 2020 Presidential election cycle and Trump will do all he can to get re-elected. For that, he needs a healthy economy, a high reading on the S&P 500 Index, low unemployment, rising wages and oh yes, no recession.

No Revolution Please, We’re British

Last Thursday was a day of feverish political frenzy in the UK. At one point it looked like the number of ministerial resignations could easily run into the double digits as displeasure within the Cabinet and the Conservative party grew with the Withdrawal Deal Prime Minister Theresa May had agreed with the European Union’s (EU) chief Brexit Negotiator Michel Barnier. Two cabinet resignations promptly followed including that of the Brexit Minister, Dominic Raab and rumours swirled that May could be pushed out in a vote of no confidence. As we waited for May to speak from the steps of Downing Street one of my staunchly Francophile colleagues remarked- “I really admire the English. They may be unhappy with Theresa May and her Brexit withdrawal deal but they don’t go out on the street and strike or carry out a revolution”. He was obviously drawing a comparison to strikes and protest, which are an essential part of life in France.

So why don’t the English revolt? Why in hundreds of years has there not been similar upheavals to the revolutions and civil wars in say, France or Russia?

The short answer is there have been revolutions in Britain – the Peasants’ Revolt of (1381), the Glorious Revolution (1688-89), the Jacobite rising (1715-1716) and others. The reason they are not remembered as well as the French Revolution or the Russian Revolution is that they were all unsuccessful. The rebels have only one success to show – the English Civil War of (1642- 1651) when King Charles I was defeated by Oliver Cromwell’s army and eventually executed. The English tried the new system – England as a Republic – for a decade, decided it didn’t work and in 1660 promptly reverted to the monarchy (albeit a constitutional monarchy with parliamentary controls) crowning Charles II (Son of Charles I) as King of England, Scotland and Ireland.

The long and considered answer is that for hundreds of years, Britain has been a more democratic nation, with a rich parliamentary history of reforms, when compared to other European nations and has granted more rights to its people sooner. The English had rights and property ownership going back over 800 years. The Magna Carta and the Doomsday Book are fine examples. The latter,a record of a huge survey of land and landholding commissioned in 1085, and the former, a charter of rights agreed to by King John of England at Runnymede, near Windsor, on 15 June 1215 that served as the foundation of the freedom of the individual against the arbitrary authority of the monarch/state. The Magna Carta became a major influence on the Constitution of the United States of America and the Bill of Rights, and the Constitutions of several other countries. Therefore, while the rest of Europe had to resort to political revolutions to win rights, the English didn’t have the same urge, or need, as the State reformed far more willingly (albeit under social pressure) and regularly.

As former US President John F. Kennedy said, “Those who make peaceful revolution impossible will make violent revolution inevitable.” Britain made “peaceful revolutions” and follow up reforms possible. The 1832 Reform Act gave a vote to the middle class. Its successor, the 1867 Reform Act gave a vote to every male adult householder living in towns. The Suffragettes movement in 1914 led to women getting voting rights. The social reforms in 1906-1914 brought in – Medical tests for pupils at schools and free treatment provided, compensation to workers for injuries at work, the introduction of a pension of five shillings for those over 70 that freed the pensioners from fear of the workhouse. In 1911, the government introduced the National Insurance Act that provided insurance for workers in a time of sickness and unemployment. And when the House of Lords resisted some of these reforms, an Act of Parliament in 1909 ended the veto of the House of Lords. Britain’s government was the model most Liberals throughout Europe sought to copy. The would-be rebels in Britain, therefore, have always had just enough “equity” to keep them from rebelling and burning down the establishment.

Source: Oxford University Press

The revolution that England is most remembered for is the Industrial Revolution and it spread to mainland Europe, including France. Further, a democratic vote in Britain is not one that is ignored or redone but implemented in toto and I have no doubt that the Brexit vote (unlike previous referendums on the membership of the EU in other parts of Europe) will be implemented in full.

On Thursday this week, May and Brussels signed off on a much-anticipated 26-page “political declaration” document that outlined the future relationship that the EU and the UK are committed to forging. A partnership that is “ambitious, broad, deep and flexible.” Just warm fuzzy words? We shall see. Agreement of the text paves the way for a special summit on Sunday at which May and the EU27 leaders will formally agree both the withdrawal agreement and the political declaration. May addressed the House of Commons in an emergency statement in which she reiterated that there would not be a second referendum as long as she was Prime Minister.

So what happens next?

The “political declaration” is very vague and has very few details about what the future relationship between the EU and the UK will be. The declaration doesn’t commit the EU to anything. It’s not a legal agreement, unlike the “Withdrawal deal” which includes guarantees that are legally binding including the £39 billion “divorce bill” the UK will pay the EU albeit over several years. Besides, the biggest bone of contention in the withdrawal deal – the Irish backstop – still remains. If, by the end of the transition period on 31 December 2020 a new trade deal between the EU and the UK is not agreed, then the Irish backstop would automatically kick in and Northern Ireland (or indeed the whole of the UK) would continue to remain part of the EU single market and customs union – i.e. UK will not be able to sign new trade deals with the rest of the world and will become a rule taker with no influence on future EU rules and regulations. Besides, once activated the backstop can only be revoked by the joint agreement of the UK and the EU. No party can individually call time on the backstop. The Brexiteers interpret this as a ploy by the EU to keep the UK in the single market and customs union for the long-term (if not forever) and deny the UK the Brexit it voted for.

I do not see the Withdrawal Bill in its current form with the Irish backstop passing through the UK Parliament and if it does, I strongly believe the Tory party will split and a new election will see Labour come to power. There is many a Conservative party voter who would not vote for the Conservative party again, such is the level of opposition to May’s Withdrawal Bill. Now, of course, all this could be averted if the deal were amended and the Irish backstop is either removed or has a fixed period of validity i.e. it pushes the EU and the UK to conclude a deal in an agreed time frame so that there is no need for a backstop to be activated. I do believe the deal will be amended. An addendum will likely appear that allays the backstop concerns when the bill is signed this weekend. Or it may not and when the bill is voted down in the UK Parliament in early December, the need for that addendum will become more urgent to avoid a No Deal Brexit. In any case, I still stick to my base case scenario that the willingness to avoid a No Deal scenario come March 29, 2019, is very high on both the UK and the EU 27 side. Therefore a solution will be worked out and the UK will leave the EU on March 29 next year and enter a transition period that will last at least until December 31, 2020.

The EU has major challenges ahead and its leaders are losing popular support. German Chancellor Angela Merkel is on her way out and French President Emmanuel Macron’s approval rating has dropped to 25% (the French hate almost all their Presidents. Francois Hollande had a 4% approval rating at one point in 2016). The Italian budget crisis and indeed Italian debt threaten the stability of the EU and the Euro and Greece is lining up for another bailout. Add to this the EU army, which I believe, will be busier averting/fighting internal battles than meeting external foes. The only countries still desperate enough to want to get in the EU are Ukraine and Scotland. In the case of Scotland, it hasn’t dawned on their leader Nicola Sturgeon that with over -8% budget deficit, Scotland is nearly three times over the budget deficit target needed to join the EU. If Scotland were to leave the UK, the savings to the UK in transfer payments to Scotland will be far higher than anything promised on the side of the red bus by the Brexiteers. If Nicola Sturgeon wants independence she should let the English vote in the next Scottish referendum.

Markets & Economy

For the fifth time this year, the S&P 500 Index (SPX) is down by more than -5% from peak-to-trough with two drops of greater than -10% recorded in January and October. Contrast this to last year when we didn’t have a single drop of more than -3% and the year finished with a gain of +20% for the index. Much of the move this year is attributed to – a maturing economic cycle, tariff uncertainty primary (but not limited) to a US-China trade war and the US Federal Reserve (Fed) in a tightening mode. Despite the market volatility, all through the year, the Fed is still set to hike 4 times in 2018 with the last hike likely to come at its December meeting. If that were the only tightening, we’d probably be fine. However, as markets are interlinked, the US Dollar has also strengthened and further tightened the financial conditions for Emerging Markets causing them to slow down. The big difference in the performance of equity markets in local currency versus in US Dollar terms highlights this currency effect (see table below). To add to this, the Fed balance sheet drain is also proceeding at a gradual pace i.e. another tightening move to add to the two above – rising rates and a strong US Dollar.

I do expect the US growth to slow down next year and therefore believe that the Fed will pause hiking interest rates. I expect the Fed to increase rates only twice next year. Having said that, I do not see a US recession on the horizon. The US economic cycle has further to run and US consumers, in particular, remain strong. The sell-off, therefore, represents a buying opportunity for global stocks. Brexit, political risks in Italy, trade tensions and a potential slowdown in China could overhang longer but don’t forget ultimately a resolution of the issues is in the mutual interest of the parties involved. No wonder European Central Bank (ECB) President Mario Draghi says there will be a deal between Italy and the EU to resolve the budget crisis and Trump is publicly signalling a détente with China.

The G-20 summit will be held at the end of this month in Argentina. In 2016, we saw a similar tightening of financial conditions with the concerns that the Fed was being too tight too soon. As a result, USD was strengthening, CNY was weakening and Oil was getting battered. The G20 summit then in Hangzhou led to a “Hangzhou pact” as policymakers decided that tightening financial conditions was not an optimal policy. Are we seeing a similar setup today? With Trump pushing publicly for a trade deal with China, the Fed starting to show some wiggle room, and China loosening its JV requirements ahead of the G-20 meeting, we could see a rally in risk assets if a deal comes to pass or even if the 25% tariffs that are to come into effect in January are postponed. Peter Navarro, the controversial White House trade policy adviser and a famous China hawk, has been excluded from the Xi Jinping-Donald Trump dinner at the G-20 in Buenos Aires on December 1. Exclusion of a famous China hawk and a key figure behind the US-China trade war indicates that both sides want to make progress on the dispute at the summit. I do see a comprehensive US-China trade deal being signed by the end of Q1/early Q2. One has to just remember – America has elections, China does not. By the end of Q2, the US would have entered the 2020 Presidential election cycle and Trump will do all he can to get re-elected. For that, he needs a healthy economy, a high reading on SPX, low unemployment, rising wages and oh yes, no recession.

In investing, a keen eye for history is always very helpful. So if you are frustrated by the volatility this year and want to sell everything and go into cash as you believe a recession is down the corner in the US, then the next three paragraphs are particularly useful for you. I suggest you read them carefully and take note of the statistics.

It’s correct that this US recovery, which started in Q2 2009, has gone on for a long time but that is no reason for it to end and a recession to set in. Australia hasn’t had a recession in 27 years and as we all know Australia is very much on planet earth just as the rest of the world and trades with earthlings and not Martians.

Here are few key stats that I came across while reading a RiskHedge report on the MarketWatch website.

• Since 1946, there have been 18 midterm elections and US stocks were higher 12 months after every single one. Yes, every single one. That’s 18 for 18.
• Since 1946, stocks have risen an average of +17% in the year after a midterm election.
• If you measure from the yearly midterm lows, the results are even better. From their lows, stocks jumped an average of +32% over the next 12 months following a midterm election.
• We’re also entering the third year of a presidential term, which is historically the strongest year for stocks (see chart below). You will note that the performance of stocks in the third year of a presidential term beats all other years by a long shot. Therefore do not throw in the towel and go into cash just yet.

In the chart above you’ll also notice the second year of the presidential cycle is typically the worst for stocks. That’s the year we’re in right now — the year when midterms occur. The SPX was as high as +9% in October and is now flat. We still have 5 weeks until the end of the year. A run to 2800 (very possible) could still make it a +4% year for the SPX.

With Germany experiencing negative GDP growth in Q3 this year, things are not looking well for the European growth story. A US-China deal, of course, would help. It seems Greece is in need of another bailout, something I predicted in the August newsletter. I wrote then – “Only in the EU could a bailout be described as ended by completely ignoring the over €330 billion that has to be repaid by 10 million people who don’t like paying taxes. Besides the taxes and regulatory burdens put on Greece as part of the bailout program have made growth unstainable and economic prospects still remain grim. The charade of interest payment deferrals and extending the maturity of the debt can only go so far. So give it a few months and Greece will be back in the news seeking a fresh bailout. Greece is like Groundhog Day but without the happy ending.” In retrospect, those words are quite prescient now. I am not bullish on Eurozone growth and don’t see how the ECB will be able to end its quantitative easing (QE) policy this year in face of a growth slowdown and negative growth in EU’s largest economy. I still prefer to be overweight the US economy and the US Dollar and find Emerging Market (EM) equities very attractive. Low oil prices are a boost to many including India, Korea, China and indeed US consumers.

Source: Bloomberg

Chinese equities (ASHR) are making an attempt to bottom. The recent lows have held so far and are right near the bear market low that was made back in early 2016. The ASHR ETF has recently made two “higher lows” (chart above), a classic bullish turning point. If the Fed policy turns more dovish and/or Trump starts to soften on trade, ASHR should see very good gains.

I believe the concerns about Apple (APPL) are overdone. Apple is not at the limit of its price premium for the iPhone. It’s true when pricing power is lost; consumer technology companies tend to either lose margins or market share or both. Apple phones are still a premium product and vast sections of consumers in the EM are yet to join the mobile phone world and get connected. I have added to Apple (APPL), Google (GOOG), Amazon (AMZN), Alibaba (BABA), Micron Technology (MU) and other tech positions to our portfolios.

I continue to be long US equities, with sector preferences for Technology (XLK), Financials (XLF), Healthcare (XLV) and Industrials (XLI). I also recommend an increased allocation to Emerging Markets Equities.

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), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM 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), 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), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital