Market Thinking

making sense of the narrative

Modest good news has an exaggerated impact.

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As Mark Twain once said, “it’s not what you don’t know that kills you, it’s what you know for certain to be true that turns out not to be”. As such, the sharp response in markets to assorted mildly positive news items was less a vote of confidence and more a reflection of a lot of hedges (against things ‘ we know for certain to be true’) catching fire if not blowing up entirely. With expiry this week we may see further hedging unwinds dominating activity.

The end of last week saw a barrage of news flow on multiple topics of concern. While the rolling 24 hour news channels continued to focus on the latest variation of the three year campaign to (somehow) impeach the US President, they barely noticed an announcement from Iran that one of its tankers had been hit by some sort of missile, or that following his announcement earlier in the week that he would be bringing troops home from Syria, President Trump actually announced he would be sending more troops to Saudi Arabia, where incidentally nobody seems to be mentioning that King Salman’s bodyguard was assassinated last week. Meanwhile, the idea that the Kurds would once again be caught up in broader middle eastern geopolitics left a lot of people shrugging their shoulders as to what it all might mean. Geopolitics as usual then and something which the market has tended to put in the ‘too difficult box’.

Instead, the market was whipsawed by issues it has previously expressed an opinion on. For example, 1) the Fed announced something akin to a new round of Quantitative easing, 2) there suddenly appeared to be some light at the end of the tunnel over Brexit and 3) also some signs of agreement on China US Trade talks.  Of course, none of these are quite what they seem, but the market response reflected the market consensus that somehow even these modest improvements ‘could not happen’.

To take them in order, the Fed move to provide a schedule of short term liquidity (which some are dubbing QE Lite) is for exactly the reasons we discussed in previous posts – ensuring on an ongoing basis that there are sufficient reserves and sufficient liquidity in the US money markets. The US Treasury is issuing a lot of paper and the Fed can not shrink its balance sheet at the same time, especially when foreigners are reluctant to be buyers. A shrinking Chinese current account surplus, so gleefully trumpeted by some as a sign of the ‘success’ of the trade war, means by definition a shrinking capital account deficit, i.e fewer US$ to be recycled into Treasuries. This is not QE in the sense that the Fed is trying to engineer some sort of wealth effect to boost the economy (always a foolish idea in my view), this is because there is a fundamental liquidity risk in the US Shadow Banking system that makes it almost impossible for the Fed to set a ‘neutral’ rate of interest. So, on balance , I would see Fed QE lite as a sign of stress in the system, not really a reason to buy.

Second. On Brexit, while the FT and others broadcast a faux outrage earlier in the week about number 10 ‘threatening to punish’ those countries which agreed a further delay in the Brexit process, anything more than a casual reading of the actual email sent to the Spectator magazine that this was referring to   (most likely to have come from Boris Johnson’s chief strategist Dominic Cummings), would have seen that this was actually a far more nuanced message aimed primarily at the Irish Government. Stating that they couldn’t see why the EU would extend the time for negotiations when there was no prospect of an agreement was calculated to bring the Irish to the negotiating table with an appeal to their long term interests. This appears, at this juncture, to have worked and both sterling and UK/European equities have rallied.  

At this point I would repeat my view that whether or not leaving the EU is ‘a disaster’ for the UK  – as is constantly ‘predicted’  – is almost entirely in the hands of any UK government decision to impose high tariff barriers across the board, something they have already declared they will not do. Economists since Ricardo have understood that the real economic benefits from trade occur because consumers get more choice and better quality at lower prices. The income accrued to exporters is not the primary benefit to the country as a whole, nor should it necessarily be for government to protect inefficient producers from global competition. As far as the UK is concerned, being a large importer, it is inefficient producers elsewhere in the EU, who are protected by the common external tariff barrier of the Customs Union that are probably most at threat, as well as those who are protected from global competition by the rules of the Single Market. This is why ‘big business’ is so keen that Brexit is redefined so as to keep the UK in the Single Market and the Customs Union. “It’s not personal, it’s just business” as the mafia used to say. 

Thus a Clean Brexit, with zero tariffs in most areas would offer the most opportunities not just for UK exporters, but also for global companies currently excluded from the UK market – and let’s be clear, there is almost nothing I can think of that the UK can not source from outside the EU. In other words, we need to look globally for potential winners. It would of course be bad for companies currently protected by the Customs Union, which means Europe as well as UK. Most obvious areas include food and clothing; the EU imposes double digit tariffs to protect Spanish and Italian citrus fruit growers for example. Meanwhile, one of my favourite statistics is that Germany, which doesn’t actually grow coffee but imports 1.5 million tons of beans, mainly for re-export, makes more money from processed coffee that is protected by tariffs than the whole of Africa makes from exporting the beans. Given the UK is a bigger market for processed coffee exports from the EU than the rest of the EU combined, the UK being able to import directly without tariffs would be meaningful for the EU coffee industry. This is just one illustration, but obviously applies across multiple industries and large corporations are understandably working with and lobbying the UK government to try and obtain favourable arrangements post Brexit. 

The important point for investors is that the (justifiable) concerns of big business are being presented by some as a reason not to leave the EU at all, as if they are the only voices in the argument and naturally they have an incentive to make the downside look as bad as possible. This ‘appeal to authority’ is but one of the multiple logical fallacies investors have been subject to over the last three years. On balance, the downside from the UK leaving the EU will be stock and sector specific with equal opportunities on the upside. For now, sterling is the only market ‘playing’ Brexit, but this will change once we get reality and past (politically motivated) speculation.

Finally, the third news item that came out last week was an apparent agreement on trade between the US and China. Investors, indeed most people, have learned to look through the hype around ‘the best deal ever’ and recognised that this was more of a postponement of an escalation than a new deal. As we have noted before, there are two trade wars – the first is about first order economics, while the second is about second and third order geo-politics. The first will come to some form of compromise, almost certainly influenced by the US Electoral timetable, while the second, the, new Cold War, looks like it will endure. 

The aim of the US administration to prevent China’s Made in China 2025 industrial strategy from developing always looked somewhat Quixotic, especially as China’s economy becomes increasingly consumer focussed, but the policies can nevertheless introduce some idiosyncratic risk. The Huawei example is the most obvious, but recent blacklisting of companies such as Hikvision and Sensetime – ostensibly for Human Rights reasons -are almost certainly part of a broader negotiation strategy and one can’t help feeling that the sudden concern for ‘minority groups in western China (or Hong Kong for that matter) is based around a wider narrative.

Thus on balance here we have upside from the trade war being resolved, but ongoing tensions and idiosyncratic risk as the US seeks to use corporates to advance its geo-political interests.

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