Recent weeks have been eventful, both domestically and globally. Boris Johnson has made it clear that his top priority is to deliver Brexit on 31 October, tensions continue in the Middle East and President Trump surprised everyone with another round of tariffs on China.
We continue to point to sterling against the US dollar or the euro to get a good idea about how investors are taking the increased talk around a no-deal Brexit. Current levels suggest that a lot of bad news has already been taken into account — after all sterling was closer to 1.45/1.50 against the dollar before the referendum vote. A word of warning though — our analysis suggests that the pound could test previous lows on any more bad news related to a no-deal Brexit or a hard Brexit.
However, what’s important to remember is that a fall in sterling is usually good news for UK stock markets, certainly for companies with overseas operations. In addition, overseas demand for UK gilts remains high as they offer better yield than many European markets. For example, German government bonds out to 30 years’ maturity all now offer negative yields.
The UK has been drawn into the crisis with Iran, with the detention of a Syrian-bound Iranian oil tanker off Gibraltar, and the retaliatory seizure by Iran of a British-flagged tanker in the Strait of Hormuz. According to the US Energy Information Administration, more than 20 million barrels of crude oil and oil products go through the Strait every day. This corresponds to about a third of the world’s seaborne oil shipments, or around 20% of global oil demand. So there’s understandable concern about the potential impact on oil supplies and prices.
However, Saudi Arabia has oil reserves which would allow it to increase its supply quite quickly. By next year, new pipelines in the US will allow larger exports of shale oil. Because of all of this, we believe that oil prices will continue to trade in the range of $60-75 a barrel as supply alters to offset demand or in response to geopolitical events.
If oil prices do move much higher, in general terms that would be favourable for stock markets like the UK’s which have a larger weighting in energy stocks. It would have implications for emerging markets too — positive for producers like Russia and negative for importers like India.
The European Central Bank (ECB) has announced that it will cut interest rates in the autumn in an attempt to revive weak inflation, while the US has announced the first cut in rates since 2008 —from 2.25% to 2.0%. This is a reflection of central banks responding to evidence of a serious recession in the manufacturing sector in most parts of the world. Global trade growth is flat, and political uncertainty has dampened business investment.
We believe a wider recession looks unlikely as the service sector is far less affected. Nevertheless, the phrase ‘insurance policy cuts’ has entered the Federal Reserve’s language. And the depth of the downturn in Europe means that the ECB needs to do much more to try and bring inflation back towards target.
That’s why ECB President, Mario Draghi, has hinted at more quantitative easing (QE) as well as interest rate cuts. The combination of the two has meant that both European equities and European high-yield bonds have performed well in recent weeks. Fiscal easing would help in Europe but sadly political barriers to that look quite high.
Other countries are following suit with rate cuts, for example Australia and India. The UK remains an exception. Certainly the economy has slowed — growth will probably be flat year-on-year this summer. However, Mark Carney and his successor as Bank of England Governor will want to keep their firepower ready for any disruption caused by Brexit. Inflation is close to target too. So watch and wait looks the best option.
The trade truce between President Trump and President Xi only lasted a few weeks before more tariffs were threatened by the US. According to the International Monetary Fund, the US-China trade wars have hurt China more than the US. In turn the slowdown in China has had an effect on other economies, especially Europe, which has had a knock-on impact on investor confidence.
For example, our analysis has shown smaller cross-border flows into emerging market equities. However, this is balanced by strong demand for emerging market bonds because of interest rate cuts in emerging market countries.
Over the summer, stock markets have tried to move to new highs before falling back. The combination of US-China trade tensions with the prospect of lower interest rates globally isn’t easy to price in.
The IMF has cut its global growth forecasts moderately for both this year and next, and these downgrades were pretty much across the board. The reasons for slowing growth centre on global trade and business investment, rather than being specific to any particular region. However, those gloomy forecasts aren’t currently reflected in the performance of many financial markets – both bond and equity prices are generally rising. Investors are already taking into account the prospect of lower interest rates and hence a revival in company profits into 2020.
Clearly there’s a danger for investors if there’s evidence that central bank policies haven’t worked, and the global economy is sliding towards stagnation or recession. However, our view is that the insurance policy cuts and other stimulus from China will have a helpful effect, that interest rate-sensitive sectors will respond, and company profits will recover from the current trough.
The EU is going through a changing of the guard, in particular with the upcoming replacements of the President of the European Commission, Jean-Claude Juncker, and ECB President, Mario Draghi. Despite this, we don’t expect a major change in policy or direction by the ECB. It’s important to remember that policies are made by a committee of 25 people, not an individual.
The concern is whether the ECB’s current policies, such as further interest rate cuts and QE, will make much of a difference. Mario Draghi appears to recognise this too, calling on EU governments to cut taxes and raise spending to help sluggish European economies.
The information in this blog or any response to comments should not be regarded as financial advice. Please remember that the value of your clients’ investments can go down as well as up and may be worth less than was paid in. Information is based on Aberdeen Standard Investments’ understanding in August 2019.