As is often the case, we find ourselves surrounded by media coverage of short-term political events. This has been accompanied by heightened levels of market volatility in certain regions, notably Asia and Emerging Markets. In this article, we consider the potential long-term investment implications of three areas currently receiving attention.
1. Global Trade
‘When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win…’
In signature style, President Trump’s rhetoric on trade has primarily emerged through his activity on Twitter. In August 2017, the President opened a formal investigation into the theft of US and Allied Intellectual Property by China, often termed ‘technology transfer’. President Trump has not only targeted China in his criticism of current trade relationships; he has also publicly attacked Mexico, Canada and the European Union.
With the exception of China, most regions have made some progress in trade negotiations with the US. In July, the EU and US agreed a new bilateral framework aiming to achieve ‘zero tariffs, zero new non-tariff barriers and zero subsidies’ on non-auto industrial goods. Significantly, they also agreed to work together to reform the World Trade Organisation (WTO). At the end of August, the US and Mexico announced a new trade deal, putting pressure on Canada to return to the negotiating table.
Whilst economists have been widely critical of President Trump’s threat of widespread protectionist measures, his underlying argument has some merit. The US has the world’s largest trade deficit and has done since the mid-1970s. The US’s largest trading partners (China, Canada, Mexico, Japan and Germany) all enjoy significant trade surpluses with the US. Theoretically, a consistent and growing trade deficit is likely to lead to job losses and slow economic growth in the long-term.
The relationship between China and the US remains complicated. With a trade deficit currently standing at c.$375bn, President Trump believes that China has more to lose from a trade war than the US. The challenge for global investment comes if a trade war becomes more widespread. Globalisation – of both physical goods and capital – has been a significant driver of global growth since the Second World War.
Conclusions
A significant increase in the barriers to global trade would undoubtedly have an impact on economic growth, and by extension, global equity markets. However, we believe that the likelihood of a protracted and widespread trade war is relatively low. President Trump has demonstrated willingness to negotiate with large trade partners. Although a negotiation with China may be more challenging, we believe that a degree of compromise is likely. This may require fundamental changes in the way China’s industrial policy deals with international business.
We continue to remind ourselves that politics can evolve quickly and are hopeful for resolutions to trade issues. Indeed, one year ago President Trump threatened to ‘totally destroy’ North Korea if forced to defend the US or its allies. One year later, we have seen the President meet North Korean leader in the first meeting between sitting leaders of the country in history.
2. Emerging Market Volatility
It has been a difficult year for Emerging Markets (EMs) with the MSCI EM index down 12.3% since its January high. As signs of slowing growth in Europe and China appeared at the beginning of the year, several EMs suffered significant economic setbacks. Increasing support in many regions of populist policies, including protectionism, initiated a ‘risk-off’ shift which further impacted EM sentiment.
Whilst EMs started to slow, President Trump continued to pump US fiscal policy. Late cycle tax cuts added fuel to an already strong economy, leading to a breakdown in the synchronisation of global growth seen in 2017. The US Federal Reserve has reacted with two rate rises already this year leaving the target rate at 2%, with two further hikes expected before the end of the year.
Higher US interest rates present two key hurdles for EM economies, the first is a reversal of capital inflows. If investment returns rise in the US investors are less inclined to search for higher returns in less liquid markets perceived to be higher risk. Some EMs are heavily reliant on foreign inflows to support current account deficits. A second key factor is the impact on USD-denominated debt and associated higher local currency servicing costs. The Bank for International Settlements recently highlighted the rise in USD-debt: growth in USD-denominated EM debt reached an annual rate of 17% last year, with the outstanding value of dollar credit to non-financial EM borrowers doubling since 2008 to $3.6tn.
The outlook is not entirely gloomy for EMs. The sector is highly diverse in terms of geography, economy and exposure to USD. Argentina and Turkey have been at the forefront of EM concerns in recent months, but they account for a tiny proportion (<1%) of the MSCI EM index and most active funds are likely to have no direct exposure to the two countries. The most significant reason for a fall in other EMs in recent months is the fear of contagion from recent currency crunches spreading to larger EM markets rather than fundamental changes within economies.
The likelihood of contagion can be explored by looking at the Argentine crisis of 2001. The situation displayed some similarities but some key differences from the ongoing difficulties faced today. The Argentine crisis of 2001 saw a complete sovereign debt default ($105bn) – the largest in history. GDP had been contracting for four years, with a total drop of 20% over the period. This is in stark contrast to the current state of the Argentine economy, which grew 4% in 2017 and is forecast just a modest contraction in 2018. Even in 2001, contagion was limited. The MSCI EM index dropped initially at the height of the crisis but increased by 16% over the following six months.
We believe that long-term investors should remain optimistic despite the short-term volatility. Over the next ten years and beyond, global growth is likely to be primarily driven by China and India. On current growth rates, over half of global growth will come from these two countries between now and 2028, providing significant compounding gains for successful companies within the regions. This will also create proximity benefits for countries with close ties to China and India as the world’s centre of economic activity is likely to continue to shift towards Asia.
Summary
The sector will likely remain volatile in the short term as the US increases interest rates and the days of extremely cheap USD borrowing end. Some emerging markets will suffer significant setbacks, but those that manage to weather this tumultuous period will continue to drive global economic growth and deliver compounding returns to investors.
3. Brexit negotiations: No-deal vs. ‘Soft’ Brexit
We have no more insight into the possible outcomes of the Brexit negotiations than anyone else. Nor do we believe that it is prudent to attempt to model the economic (or market) implications of the range of possible outcomes. Instead, we turn to historical periods of political and economic stress in the UK in an attempt to draw some broad conclusions on where we stand.
1970s: Stagflation, Sterling Depreciation and Stock Market Volatility
Britain joined the European Economic Community (EEC) in January 1973, having twice been denied membership during the 1960s. One implication of membership was the introduction of the Common Agricultural Policy on UK farmers. This supported agricultural wages and led to inflationary pressure on land prices. At the same time, Arab oil-producing nations were reacting to the perceived Western support of Israel in the Yom Kippur War, leading to the imposition of an oil embargo in October 1973. Oil prices had quadrupled by the time the embargo was lifted (from $3 to $12/bl), putting pressure on transport costs and the manufacturing sector. Trade Unions were also proving politically and economically problematic, with Miners’ Strikes in particular having a severe impact. The Conservative government of Edward Heath was twice forced to introduce a three-day working week before facing defeat by Harold Wilson’s Labour party.
The economic impact of this series of events was severe. The UK faced fourteen consecutive quarters of recession in 1973-5, with overall GDP declining by 3.9%. Unemployment remained high throughout the period, peaking at 9% in May 1975. Inflation exceeded 24% in 1975, despite interest rates remaining at 12-14% throughout the recession. Sterling depreciated by over 30% between 1971 and 1977.
Contrasting this period with the situation in the UK today demonstrates the relative stability currently enjoyed. Although GDP growth has slowed moderately in recent years, we have enjoyed long periods without sustained recession. The Global Financial Crisis initiated five consecutive recessionary quarters, the most since the 1970s. Inflation has been relatively stable, peaking at 4.8% in September 2008 and remaining between 0-3% between 2012 and today. Unemployment has been steadily declining, now sitting near record lows at c.4%. The main observable impact of Britain’s decision to leave the EU thus far has been the depreciation of Sterling, falling from $1.49 pre-referendum to the current level of c.$1.30.
1990s: Black Wednesday, Currency Crisis and the European Exchange Rate Mechanism (ERM)
A booming UK economy in the mid to late-1980s was accompanied by high levels of inflation. In Europe, countries were moving towards the goal of a currency union, with Italy, France and Spain tying their currencies to the German Deutschmark. Believing that a pegged currency could bring inflation under control, the UK joined the ERM in October 1990. By September 1992, the divergence between the UK and German economies left Sterling at the lower limit of the ±6% band. Speculators, most famously George Soros, started buying UK Gilts with the intention to sell them back to the Bank of England before buying again at a lower price. John Major raised interest rates from 10% to 12%, then to 15% in one day. The move was not enough, and the UK crashed out of the ERM on 16 September 1992.
The eventual impact of these events was overwhelmingly positive for the UK economy. Sterling depreciated c.35% against the dollar over six months, leading to a major economic recovery. The ‘Great Moderation’ period followed, with the UK experiencing 63 consecutive quarters of positive economic growth. The UK’s experience of the ERM was not a positive one. It demonstrated the challenges of tying divergent economies together. It could be argued that the European Sovereign debt crisis of 2010-11 was another example of such challenges. Southern European economies remain structurally different from those of Northern Europe. Without full fiscal union, monetary union remains difficult, as evidenced by continued political unrest across Europe.
Conclusions
Neither of these case studies is intended to provide a ‘prediction’ into what the UK will experience following Brexit. However, they do provide some context. The UK economy remains strong and looks likely to be able to withstand a significant shock in a way that it was not able to in the 1970s. One of the most significant consequences of economic union is often a fixed or semi-fixed exchange rate. The UK does not have this issue to negotiate – Sterling is free to float according to investor demand. This should provide at least a partial counter-balance to any negative shocks faced.
In the wider context of global investment markets, Brexit negotiations remain relatively insignificant. Whilst the process is emotionally and potentially economically and politically sensitive to those of us living and working in the UK, we encourage clients to maintain perspective. Relative to historical shocks, the process has thus far had relatively little impact on the UK economy. Whilst it is important to continue monitoring this, it is also important to consider our investment horizon and the global nature of client investment portfolios.
Investment Conclusions
- Market corrections are part of every cycle
We believe that a market correction at some point is a certainty. We do not believe that this cycle is different from the past in that regard, despite having been supported by record low interest rates. What we are uncertain on – and would encourage clients to avoid attempting to predict – is the timing of any such correction. Those that have been ‘calling’ the top of the market for the last year, two years, five years, will at some point be correct. Indeed, if you say something often enough, it will eventually be true (regardless of whether predictive power was involved).
- Volatility is expected to increase
Despite recent commentary surrounding increased levels of volatility in the market, volatility remains very low by historical standards. Given our belief that this cycle is fundamentally no different from any other, we anticipate an increase in volatility as and when markets do correct. We do not believe that this is a reason for clients to dis-invest but do encourage clients to remember that equity investment should be viewed as a medium to long-term investment.
- Markets typically recover within five years of a correction
| Source: Thomson Reuters Eikon | Market high | Market low | Price change | Date of recovery to previous high | 3 years post low | 5 years post low | |
|---|---|---|---|---|---|---|---|
| Economic crisis in Asia (MSCI Asia) | 1997-1998 | 304.76 (2 Jul 97) | 124.78 (1 Sep 98) | -59% | 26 Dec 2005 | 159 | 191 |
| Collapse of tech bubble (S&P 500) | 2000-2002 | 1527.46 (24 Mar 00) | 776.76 (9 Oct 02) | -49% | 30 May 2007 | 1185 | 1565 |
| Financial crisis (S&P 500) | 2007-2009 | 1565.15 (9 Oct 07) | 676.53 (9 Mar 09) | -57% | 25 March 2013 | 2371 | 1868 |
| Financial crisis (FTSE 100) | 2007-2009 | 6730.71 (12 Oct 07) | 3512.09 (3 Mar 09) | -48% | 21 May 2013 | 5911 | 6708 |
| European debt crisis (Euro Stoxx 50) | 2010 | 2711.84 (15 Apr 10) | 2285.13 (25 May 10) | -16% | 4 Feb 2011 | 2786 | 3510 |
- Current investment outlook
We remain broadly positive on Global equity markets, with fundamentals continuing to look strong. However, the end of quantitative easing in some regions (Europe), political uncertainty in others (UK, Asia) and the advancement of monetary tightening in later-cycle economies (US) all present challenges in the short to medium term. We continue to believe that Fixed Interest will not be the ‘low-risk’ asset class that it has been in previous cycles. Infrastructure assets provide attractive diversification benefits and would benefit from fiscal expansion which may accompany monetary tightening. We remain neutral on commercial property, which continues to deliver attractive yields but with uncertainty over continued capital growth.
Our investment advice remains consistent: stay invested in well-balanced, globally diversified portfolios to benefit from the compounding of returns over time. When a market correction occurs with such diversified portfolios, there is unlikely to be permanent loss of capital over a medium to long-term horizon. Judicious asset allocation can allow increased weightings following market weakness. Cantab’s recommended client portfolios are diversified across asset classes, reducing volatility when individual equity markets correct and allowing management of asset allocation across a cycle.
Risk warnings
This document has been prepared based on our understanding of current UK law and HM Revenue and Customs practice, both of which may be the subject of change in the future. The opinions expressed herein are those of Cantab Asset Management Ltd and should not be construed as investment advice. Cantab Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. As with all equity-based and bond-based investments, the value and the income therefrom can fall as well as rise and you may not get back all the money that you invested. The value of overseas securities will be influenced by the exchange rate used to convert these to sterling. Investments in stocks and shares should therefore be viewed as a medium to long-term investment. Past performance is not a guide to the future. It is important to note that in selecting ESG investments, a screening out process has taken place which eliminates many investments potentially providing good financial returns. By reducing the universe of possible investments, the investment performance of ESG portfolios might be less than that potentially produced by selecting from the larger unscreened universe.
