A view from the markets – UK set for stability
Politics will remain a key driver of market volatility in the coming year given a new UK government, the US election and potential political change in Germany. Yet beyond these events, the medium-term agenda will increasingly be set by the interaction between fiscal policy and the need to combat climate change. There are significant implications from accelerating the policy agenda, in terms of potentially higher energy costs, increased investment in new technology and the displacement of old and creation of new jobs. There will be implications for the financial sector too. Central banks are increasingly entering the climate change arena with associated risks increasingly being identified as threats to financial stability. This will be a theme to constantly return to in 2020.
There were two and a half risk-off months this year with May and August being the most significant (March less so). The negative returns for risk assets in those months were all driven by fears of an economic slowdown and the uncertain outlook for global manufacturing in the context of an aggressive US trade policy. For the rest of the year, markets have responded to more central bank support. The last three months have been very risk-on with equities outperforming bonds by a significant amount and, within fixed income, credit sectors outperforming rates. As a result the full-year performance for most asset classes is significantly better than it was in 2018. Investors put a lot of store in central bank support and the (hopeful) impact that has in staving off a more serious downturn in global growth.
Hostage to tweets
Our end-of-year view is that returns in 2020 might not be as exciting. Despite the general risk-on tone in markets, we were reminded this week what a hostage to President Trump’s unpredictability investor sentiment has become. In a suggestion that he might not need to get any kind of trade deal done with China until after the election, the President managed to send Treasury yields 15 basis points (bps) lower in one day and the S&P500 into a 3-day losing streak. In all likelihood it was a pretty off-the-cuff comment and subsequent intelligence suggests that a deal might be close. However, markets are skittish and if the main reason why we had three negative months for risk assets this year is fear of more protectionism, then it is no surprise that when those fears re-emerge, markets sell-off. It also makes it hard to have any confidence about the path of returns in 2020 when there is a chance that the US-China trade relationship could play a role in the politics of the US Presidential election. On average returns might be lower next year and volatility might be higher.
UK to enter a period of relative stability?
That volatility of risk-market returns is more than likely going to remain tied to political events. To kick-off we have the UK election next week and the subsequent economic and political path the UK will be on following the results. We should expect some fiscal stimulus with the Conservatives saying this week that they will raise the National Insurance threshold almost immediately, delivering a tax cut for millions, in addition to quickly increasing spending on the National Health Service and schools. If Labour win there would be even more spending but a more negative reaction in the markets given proposals to nationalise certain industries, raise borrowing significantly and increase corporate taxes. I was totting up in my head the numbers of new police, teachers, doctors and nurses that the two major parties are promising to appoint. It’s a good job there are still 1.3mn people unemployed because otherwise I don’t know where they are going to come from (if only the labour market worked that easily!). The recent rally in sterling has boosted returns from UK assets to foreign investors (the ICE/BAML Sterling Corporate bond index is sitting on total year-to-date returns of 10.76% in sterling and 16.6% in Euro terms; the FTSE-100 price return so far this year has been 12.9% in Euros versus 6.1% in sterling). It is not clear whether this will continue but there is certainly the potential for the pound to continue to strengthen, after all it has been as high as $1.44 against the dollar in the post-referendum period). Sterling assets appear to be under-owned in global portfolios because of the last few years of Brexit uncertainty. A degree of political stability, post-election, could see some change to that situation. Indeed, outperformance of sterling assets versus the euro could be a theme of early 2020.
Cracks in the coalition
Part of that trade could be growing concerns about the politics of the EU. In Germany there is a risk that the grand coalition between the CDU, led by Angela Merkel, and the SPD could come to an end following the election of two leftist co-leaders of the junior partner. Both parties are struggling to command support amongst the electorate and if the SPD were to leave the coalition – because of a likely shift in its position on fiscal policy and the lack of enthusiasm for the coalition agreement amongst the new leadership - then a collapse in the government could mark the beginning of a period of political uncertainty in Germany. The Greens and the right-wing AFD parties have gained support at the expense of the coalition parties. Merkel would depart the stage, which would have implications for the European level political situation.
Zero black might become greyed
Within Germany there is lots of talk about the outlook for fiscal policy. The new SPD leadership would be less inclined to support the “black-zero” approach to balancing the budget while the Greens, if they were to gain support after any election, would favour a significant increase in climate change related government spending. Things are far from clear at the moment but it is interesting to see how German government bonds have traded in recent weeks. The 10-year Bund yield is 40bps above its August lows. I don’t expect much to happen in the short-term as both the SPD and the CDU have a vested interest in keeping the coalition together, but the changes in the SPD make the coalition look significantly more fragile. If Germany shows any sign of loosening its fiscal stance, I would suggest that would be the green light for other countries in Europe to do the same. Given that not all of them have the fiscal credibility of Berlin, wider sovereign credit spreads are something that we could see again in 2020. Again, instructive that that Italian-German spread has been steadily moving up in the last couple of weeks. AS the UK possibly enters a period of relative stability in politics, compared to the last three years, Germany could be entering a more unstable time. Given the Euro’s growing role as a funding currency, a move in Euro/Sterling back below 0.80 is one of the key potential FX moves for next year.
A broader and longer-term issue concerning fiscal policy is whether governments will start to adapt fiscal policies to the needs of climate transition – both on the spending side but also on taxation, particularly around carbon taxes. The IMF, in a recent blog on its web-site, states that around 50 countries have some form of carbon pricing scheme with an average cost of just $2 per ton of carbon emission. It suggests that something closer to $75 per ton would be necessary to help finance the transition to a lower carbon economy and fund offsetting spending for industries and communities displaced from a more rapid retreat from carbon fuels than is currently the case. A similar line of argument has also recently been put forward by the United Nations. This would imply a sharp rise in household and business energy costs during the transition from carbon to renewable energy being the dominant source. There would also be significant implications for businesses that have traditionally been linked to carbon production, energy generation and carbon usage – think chemicals, steel and many forms of transport.
Macro implications are not fully understood
We in the private sector can do a lot to help in the carbon transition economy, through the provision of finance to greener activities while at the same time striving to have a more credible and transparent approach to integrating environmental goals into investment strategies. However, the real meat will come from government action. If governments did start to tax carbon production more aggressively tax there would be inflationary and growth implications and the challenge would be to design policies that ensured that the development of renewable energy sources was quick enough to offset higher consumer energy prices. Monetary policy will also be impacted given that the financial system’s stability will be challenged by the assets that investors and the banking system have with companies in those industries that are in terminal decline. Expect to hear more form central banks about how climate risks will be incorporated into stress tests for financial companies, both banks and insurance companies.
Climate risk is the fig leaf for more spending
Politicians are always wary of promising too much. However, the need to combat climate change is a great fig leaf to cover using fiscal policy more aggressively. On the spending side the carbon transition process should spur investment and jobs. At the same time, if we are successful, then external costs related to extreme weather, human displacement and health problems might not become as bad as they are likely to be if temperature increases are not controlled. Most of the commentary around climate change is gloomy but there is more optimistic way forward, which could have tremendous economic and investment benefits, if we can just get the political leadership and commitment. This is the real importance of the political cycle. It is a difficult message to sell – you have to pay more in the short-term to save the planet in the long-term – but surely one which politicians should increasingly become more honest about. Investors have to be prepared for more policy targeted at carbon transition and more turbulence in the real economy as that transition evolves. There will be winners and losers in the equity and bond markets, and macro-economic implications if fiscal policy does start to be driven more by accelerating reduced carbon usage. For me this is a reason to have some inflation-linked bonds in portfolios to protect from any policy induced rise in consumer prices from energy transition. I will explore other investment implications in 2020.
Job losses rising (in the premier league)
‘Tis the season to be jolly – except if you are a Premier League manager. Four have gone in recent weeks, including the bosses of the two north London giants. Just a few days ago there was also talk that Ole Gunnar Solksjaer would be the next manager to get the (Santa) sack. However, his Manchester United team managed to beat Tottenham 2-1 in mid-week, adding another Old Trafford defeat to the resume of Jose Mourinho (sadly a lot of the others were when he was manager of the Reds). It was a much better performance from United and especially from Marcus Rashford who is turning out to be one of the only highlights of this season. The Manchester derby, this weekend, will be a tougher gig. United have only won 1 of the last 8 league meetings with City, but Pep’s boys have looked a little more vulnerable recently and United’s record against the top six clubs is not bad. A win should secure Ole is working this Christmas and has the chance to strengthen the squad in January.
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