Look outside the UK for investment returns
Amid the constructive outlook for global equity prices, the UK appears the exception, with the FTSE 100 Index lagging its peers so far this year in local currency terms. The UK is the one major economy where GDP growth is not expected to accelerate in 2018. In part this is due to rising political risk and the trickle-through impact it has on domestic demand.
Brexit: winning or losing?
Although PM Theresa May secured a Brexit divorce deal in December and has moved onto UK-EU trade talks, it has come at a cost. The UK apparently faces a binary choice between i) being a member of the internal market and customs union (a similar deal to Norway’s relationship with the EU), or ii) accepting a Free Trade Agreement (like the Canada-EU deal), with limited market access for services, but free trade in goods. Unless the EU softens its stance that the UK cannot “cherry pick” Brexit terms, it is becoming clear that the British government has to accept a Norway- type deal, or no deal.
For Brexit-supporting Tory MPs, who were reluctant to approve a c. £40bn financial settlement with the EU, the divorce agreement may not buy the status quo. It could instead deliver a rather more restrictive trade agreement, with free movement of labour intact, as well as budget contributions and jurisdiction by the European Court of Justice. This may in turn lead to a backlash within the Tory party that leads to a snap general election.
With the Tories lagging behind Labour in the opinion polls, the real risk to UK investors is that the chance of Jeremy Corbyn becoming PM has increased. A Jeremy Corbyn government could mean a reversion to 1970s hard left policies of nationalisation, punitive taxes, fiscal relaxation and other monetary experiments.
Given these concerns, it is not surprising that UK equities are underperforming global markets. On a fundamental level, we believe that investors should be looking outside the UK for equity returns in order to take advantage of faster growth in company earnings, still accommodative policy and less political risk.
Making America great again – dollars and sense
A key risk for equity markets would be if Treasury bond yields rise quickly and this leads to a sharp appreciation in the US dollar, the world’s reserve currency.
Conceptually, dollar appreciation is a substitute for monetary tightening that raises credit risk for borrowers with exposure to dollar-denominated debt. It draws dollar liquidity away from the rest of the world (e.g. emerging markets), and could potentially lead to a tightening in market liquidity and renew deflationary forces in the global economy. Nevertheless, we see the risk of dollar appreciation as fairly low for three reasons, and they are largely related to President Trump.
First, Mr. Trump can use his notorious Twitter feed to influence a lower dollar exchange rate. For example, President Trump’s comment in a Wall Street Journal interview that “our dollar is getting too strong” in January 2017 ended the upward trend in the dollar that began some years previously. If the president really wants to fulfil his presidential slogan to “Make America Great Again”, and increase the competitiveness of the US sufficiently to bring jobs back onshore, then he needs the dollar to depreciate.
Second, Mr. Trump can influence monetary policy somewhat through his appointments at the Federal Reserve (Fed). Members’ terms are staggered so that the President can only appoint two members and a chair during each four-year term.
However, given current vacancies, Mr. Trump will have the opportunity to replace all Fed governors during his term in what will be the biggest regime change at the central bank since 1936. He may pick more dovish candidates in order to keep interest rates down to finance his infrastructure spending plans. With these personnel changes expected, the Fed’s current interest rate projections, which are higher than market forecasts, should probably be taken with a pinch of salt.
Third, Congress has agreed to legislate most of Mr. Trump’s tax cutting and tax reform agenda. The end result is that it should lead to a widening fiscal deficit.
Historically, a wider US budget relative to the rest of the world has often led to a weaker dollar. That’s because greater US fiscal expenditure increases the supply of dollars in the global economy and reflates growth in other parts of the global economy.
Moving into 2018, the dollar has resumed its downward decline, but it has not had an adverse impact on markets. That’s because US import price inflation remains fairly low and has had a limited impact on raising consumer prices. Provided global inflation remains benign (our base-case view), a weak dollar should continue to support both market liquidity and equity prices.
All values and data correct as of 31 January 2018. Sources: FTSE, Thomson Reuters Datastream, Bloomberg