Market Viewpoints

Summary:

The Brexit negotiations are in limbo because UK Prime Minister Theresa May is not only absolutely convinced her deal is the right deal, but she is also convinced that the UK must not leave the European Union (EU) without a deal. On the other hand, the EU doesn’t want to re-open the Withdrawal Agreement and remove the backstop that would ensure the passage of the deal in the House of Commons. Additionally, the EU is not prepared to deal with the consequences of a UK exit from Europe, and is therefore only too happy to extend the article 50 deadline with the hope of getting the UK to change its mind and not leave. A third Meaningful Vote is in doubt. What is not in doubt in my mind, is that if Theresa May were to lose this vote, her fate would be sealed and she will be out of 10 Downing Street. A new leader and a general election could follow in quick succession as Brexit is delayed. In my opinion, the events of last week have raised the probability of a no deal, be it now or indeed after a general election. Recent polls indicate that public opinion against a delay to Brexit, and leaving with no deal if need be, is hardening.

Elsewhere, when investors hear the words, yield curve inversion, they automatically think, recession. This is because every recession in the US since 1962, nine in all, has been preceded by such an inversion. However, it is also worth remembering that not every inversion has been followed by a recession and that the lag between an inversion and an ensuing recession has lasted anywhere from 7 to 24 months, with an average of 14 months.

Mañana

Another European Union (EU) council meeting has come and gone. The Brexit deadline has been pushed back. The annoying Brexit countdown clock on Sky News has been rendered useless and reset. The answer to – “When will Brexit be resolved?“ 1005 days after the referendum, continues to be mañana. Last Thursday, over a three-course dinner of green lentil terrine with langoustine, roast duckling a l’orange and chocolates, UK Prime Minister Theresa May and the EU 27 came up with a solution which can only be called a fudge – the UK will leave on May 22, if the UK Parliament backs May’s Brexit deal. If the deal is voted down, Britain will have until April 12 to pick between no deal and agreeing to hold European elections in return for a longer extension to the Article 50 process. May has categorically rejected the idea of the UK taking part in European elections, at least for now. The Meaningful Vote – or MV for short, now stands for May’s Vanity. She has no support for it in the UK Parliament and on Monday the parliament voted by 329 to 302 – a majority of 27 – for a cross-party amendment to enable MPs to stage a series of “indicative votes” on alternatives to the Prime Minister’s deal. It is hoped that the “indicative votes” would result in one option, securing the support of a Commons majority. However, it’s also possible that, ultimately, Parliament fails to coalesce around a single option, and we end up back where we started.

A baffled Swiss journalist was quoted in the Daily Telegraph asking – “My country is a democratic country. We always enact the result of our referendums. We greatly admire your country [UK], especially your House of Commons. Please, can you explain why it is refusing to enact what the people decided? Your MPs who do this seem to us to be enemies of the people”. I am afraid the Swiss reporter is spot on. It is very odd that the result of the largest democratic vote in the history of the UK should be so rudely fudged and every effort spent by an overwhelmingly “Remain” Parliament to delay or only partially implement the result. The disconnect between MPs and the people has been in the open since the referendum took place. While the country, by parliamentary constituency, voted 406 to 242 to leave the EU – a surplus of 164, MPs voted 486 to 160 to stay, a deficit of 326. This disconnect is the biggest obstacle to getting Brexit resolved and only a general election can narrow the Leave vs. Remain gulf in the House of Commons. I see no other way of achieving this.

The Brexit negotiations are in limbo because May is not only absolutely convinced her deal is the right deal, but she is also convinced that the UK must not leave the EU without a deal.

The Brexit negotiations are in limbo because May is not only absolutely convinced her deal is the right deal, but she is also convinced that the UK must not leave the EU without a deal. On the other hand, the EU doesn’t want to re-open the Withdrawal Agreement and remove the backstop that would ensure the passage of the deal in the House of Commons. Additionally, the EU is not prepared to deal with the consequences of Brexit and therefore is only too happy to extend the article 50 deadline in the hope of getting the UK to change its mind and not leave the EU. The Eurozone Purchasing Managers Index (PMI) Index for manufacturing numbers out last week makes grim reading and indicates that the region is teetering on the brink of recession, as a manufacturing slump in Germany and France – its two biggest economies- shows no signs of abating. A no deal Brexit, in such a circumstance, would only make the Eurozone’s problems worse.

Purchasing Managers Index (PMI) Index for Manufacturing

Source: Bloomberg

The PMI number for Eurozone (MPMIEZMA in the chart above) fell to 47.6 in March, from 49.4 in February. This index was at 60.6 back in December 2017. A reading below 50 indicates a contraction. France’s business activity in both services and manufacturing (MPMIFRMA) is now also in contraction zone. Meanwhile, Germany’s vast manufacturing industry shrank at the quickest rate in more than six and a half years. Germany Manufacturing PMI (MPMIDEMA in chart above) slumped to 44.7 in March, from 47.6 in February. The index was at 63.2 back in December 2017. UK’s manufacturing PMI (MPMIGBMA), however, is at 52, despite Brexit, but you wouldn’t know that from the Brexit scare stories that UK’s media love to report.

In my opinion the events of last week have raised the probability of a no deal, be it now or indeed after a leadership change in the Conservative party, which looks all but inevitable. Recent polls indicate that public opinion against a delay to Brexit and leaving with no deal, if need be, is hardening. Don’t be fooled by the #PeoplesVoteMarch. London voted overwhelmingly to Remain in the EU and organisers should try holding the next march up North and see how many from London are committed enough to travel up there to march for Remain. I never thought I would agree with any of the marchers until I saw this banner…”Ikea has better cabinet” with which I wholeheartedly agree. Both the Tory Cabinet and the Labour shadow Cabinet are a disgrace, to put it politely. Of course, a no deal outcome will send everyone scurrying to find a new deal and may be the only way to resolve the stalemate and establish a forward-looking trading relationship between the EU and the UK.

A third Meaningful Vote could still take place later this week, if May thinks she will not lose again. The 10 MPs of the Democratic Unionist Party (DUP) have opposed the Withdrawal Agreement in both previous votes and their “position remains unchanged.” What is not in doubt in my mind is that if Theresa May were to lose the third Meaningful Vote, her fate would be sealed and she will be out of 10 Downing Street. A new leader and a general election could follow in quick succession, as Brexit is delayed.

US-German relations at a breaking point

Ever since US President Donald Trump was elected, US-German relations have been frayed and may have now reached a breaking point. The US has pushed North Atlantic Treaty Organization (NATO) members to pay their dues, threatened Germany with crippling tariffs on its auto exports to the US, opposed Germany’s Nord Stream 2 gas pipeline project – a new natural gas pipeline through the Baltic Sea to supply Russian gas to the key EU market, and warned against purchasing Chinese 5G technology from Huawei, that US administration officials believe could present a security threat.

In recent months, Berlin has rebuked Washington’s demands that Germany limit purchase of gas from Russia, ban Huawei from its 5G network, and prevent German companies from doing business with Iran. Germany is now poised to renege on its pledge to meet NATO’s defence spending target. Last year, German Chancellor Angela Merkel publicly pledged to increase German military expenditure to 1.5% of GDP by 2024. However, the spending plans outlined by the German Finance Minister Olaf Scholz last week, will see German defence spending drop well below the 2% Gross Domestic Product (GDP) by 2022. By comparison the US’s defence budget for 2019 is $686 billion, approximately 3.5% of GDP. US ambassador to Germany, Richard Grenell remarked – “NATO members clearly pledged to move towards, not away, from 2% by 2024. That the German government would even be considering reducing its already unacceptable commitments to military readiness is a worrisome signal to Germany’s 28 NATO allies.”

And if Germany hadn’t defied the US enough already, Berlin, instead of countering China and its Belt and Road Initiative (BRI) making inroads deep into the Eurozone, is now embarking on a summit meeting between EU heads of Government and Chinese President Xi Jinping next year. Germany holds the EU presidency from July to December 2020. The Chinese have bought into the Greek port of Piraeus and are eyeing the development of the Atlantic container port of Sines in Portugal. In Italy, ports like Trieste and Palermo are also of interest to China.

Source: The Economist Group Limited, London (2 July 2016)

As Germany pushes the EU to seek a closer relationship with China and warms up to Russian gas, sceptics will say Germany has forgotten the sound of Soviet tanks rolling across the German mud. However, Germany has urgent concerns of its own. For the last two decades, Germany has relied heavily on its industrial exports to China and in particular auto exports to the whole world. With the auto sector hitting peak growth, the decline in production impacts the whole auto-sector supply chain – from chemicals to plastics, rubber and auto ancillary. Given Germany’s dominance in manufacturing and auto sector supply chain, it is one of the worst affected and in Q4 last year German economy escaped a technical recession by the skin of its teeth. Last year, Chinese imports from Germany fell by -37%. Besides an improving US-China relation also means China buying more from the US in order to shrink its trade deficit with them. China buying more from the US means China buying less from the rest of the world. The size of China’s local market and the ensuing demand means Germany has no option but to seek a better and closer relationship with China to support its own export-oriented economy until such time that Germany can reduce its dependency on exports by stimulating its own domestic growth and that of the Eurozone. However, that will be a slow process and it is fraught with risks.

China buying more from the US means China buying less from the rest of the world.

To make matters worse Europe and Germany have fallen behind in 5G mobile internet technology. The 5G mobile internet connectivity promises much faster data download and upload speeds, wider coverage, more stable connections and increased capacity. The 5G technology is expected to officially launch across the world by 2020, when Europeans will become painfully aware of the shortcomings in innovation policy in their telecommunications. China’s Huawei is a leader in 5G technology and therefore Germany has refused to ban them despite the pressure from the US. Merkel reiterated that her country would instead tighten security rules. “Our approach is not to simply exclude one company or one actor”, she told a conference in Berlin recently, “but rather we have requirements of the competitors for this 5G technology”. Banning Huawei without the availability of an alternative will handicap Germany in the technological industrial revolution that is playing out.

Markets & Economy

While the S&P 500 (SPX) is meeting stiff resistance at the 2820 level, equity returns so far in 2019 have been very impressive. One quarter into 2019, Year-To-Date (YTD) the SPX index is up +11.6%, Europe’s flagship index, Euro Stoxx 50, is up +10.6% and MSCI Emerging Market Index is up +8.5% (table below).

The yield curve inversion – when the yield on long-term debt drop below its shorter-term (chart below) caused quite a stir last week and saw a sharp sell-off in the equity markets towards the end of the week, this despite a very dovish US Federal Open market committee (FOMC) meeting which left the Federal Fund Rate between +2.25% and +2.5% and indicated that it may not raise rates further this cycle.

Source: Bespoke Investment Group (B.I.G)

Normally, the yield differential between short term debt and long-term debt, would be an upward sloping line. The higher long-term yield reflects the sentiment that growth will continue, and therefore the higher yield for the longer-term debt compensates an investor for the greater risk of inflation that growth will bring and chip away at the real value of the investment. But when the difference between the yield on the short-term debt and long-term debt narrows, it’s a signal that investors are less convinced growth is here to stay. The yield curve therefore first flattens and then inverts.

When investors hear, yield curve inversion, they automatically think, recession. That’s because every recession since 1962 (chart below) has been preceded by a yield curve inversion. However, what is also worth remembering is this – not every inversion has led to a recession (chart below, the shaded region is recession). The San Francisco Fed measured the yield differential between Ten-year and One-year Treasury Notes and the lag between the inversion and the ensuing recession lasted anywhere from 7 to 24 months, with an average of 14 months.

Source: Bespoke Investment Group (B.I.G)

So should we be worried about yield curve inversion and start selling equities?

Certainly not. While the correlation between recession and yield curve inversion is beyond doubt, it’s important to bear in mind that the US Federal Reserve (Fed), as in past yield curve inversions, is not currently raising rates in an attempt to fight inflation. This is for good reason, since inflation remains completely contained and is infact undershooting the Fed’s expectation of +2% p.a. So, much so that they are now thinking of following easy monetary policy for longer to get the inflation higher.

People are taken in by curve inversion too easily. Quantitative easing (QE) has changed everything. Old playbooks are relevant but do not apply. If the Fed wasn’t holding nearly US$ 4-trillion dollars of securities on its balance sheet, where would the 10-year yield realistically be right now? Higher and there would be no yield curve inversion. Therefore, to me, yield curve inversion is a sign of a slowdown in economic growth and not of a recession, at least not in the next 6 months. What the yield curve inversion is really telling us is this – the Fed went too far during the last 12 months in raising rates and a rate cut may not be far enough if the slowdown continues and a US-China trade deal fails to lift growth.

One last thing on US equities. Unless the decline in the SPX continues further, we are about to see a very bullish technical signal at some point this week – the vaunted “Golden Cross.” It occurs when an Index or security’s 50-day moving average crosses above its 200-day moving average, as both moving averages are on the rise (chart below). The upcoming Golden Cross for the SPX would be its first since April 2016. Historical daily return data crunched by the Bespoke Investment Group, indicate that there have been 25 prior Golden Crosses for the SPX dating back to inception in 1928. The returns over the next month, 3 months, 6 months and 12 months after have been positive, with the 12-month return averaging +6.21% after such occurrences.

S&P 500 index: Last 12 Months

Source: Bloomberg

So, in light of all of the above, my allocation still remains overweight to US equities. I also feel very positive about Emerging Markets (EEM US) as the US Dollar gets weaker versus the EM currencies. While the Chinese tech stocks (Alibaba, Baidu, JD.com) and semiconductor stocks (Micron Technology, Qualcomm, Nvidia) have rallied a great deal over last few weeks, the rally is not done yet. As for US sectors, I like Energy (XLE), Industrials (XLI), Financials (XLF), Communication Services (XLC) and Healthcare (XLV).

Other stocks I like: 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), Lam Research (LRCX US), VINCI (DG FP), Taiwan semiconductor manufacturing company (TSM UN).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital