International Tax, Impact Investing, Structured products, ETFs, Private Equity, Planning
2017 – The year so far..
The predictions that I made have by and large come about, or are in the process of unfolding.
The most important is the USA. Trump and his administration have not long been in power, but already it can be seen that his pre-election stances and promises are having a hard time coming to fruition. This is not surprising since many of them flew in the face of economic reality. Digging for more coal is not on, since it is not price competitive as well as being polluting. Shale gas is now powering more and more US generating plants and is cheaper and cleaner than coal. Even on the environment Trump has done an about turn and now agrees with the Paris accord, at home however he is still intent on relaxing restrictions. His inability to push through a replacement of Obamacare has caused doubts about his level of support for other measures and Wall Street and the business world now wonder what will happen to the promises on corporate and individual tax reductions. Trump is still in trouble on healthcare and in recent days is urging the Democrats to meet his ideas in some way. He is urgently addressing tax reductions so as to kick start the economy and boost corporate earnings – he needs to since at the moment it is not obvious where further growth is going to come from. On this subject he may have more encouragement from the Democrats.
His other expensive programmes such as increased military spending, infrastructure and the Mexican Wall have all to be approved and really get started. It seems unlikely that these programmes will be approved in the next few months, unless some deal is struck, and that they will have to be approved in the next Budget for 2018. In addition such programmes spread out over several years and do not have an immediate impact. Nonetheless if they do get started they will generate more confidence. US stock markets are being held up by confidence and the Trump Trade. Any doubts about those factors and the markets will react downwards. US stock markets have risen to historic highs and the average P/E ratio is 25.45, with a mean going back to 1880 of 15.65. The current ratio is not particularly speculative and has been buoyed up by increased earnings. In the 1930s slump it hit 10.30 and in 2007 / 2008 period it hit 63.
The S & P 500 index has increased by 18.4% over the last year and by 5.1% in the last 3 months. The VIX volatility index is at 9.65, which is historically quite calm. However all the main US indices hit record highs in the last week and the Relative Strength Indicator ( RSI ) S & P 500 climbed over 70, which indicates an oversold position. So this can indicate a correction in coming weeks by some selling.
To my mind the indices which need watching are the unemployment rate of 4.2% in September 2017 and inflation at 1.9% at the same date. It is said that if the unemployment rate continues below 5.0% for any length of time then the US stock markets will drop. Well, the rate has been below 5.0% since April 2016. The inflation rate is at its highest since 2012 and been 2% and over since December 2016. Little wonder then that the FED is gradually raising interest rates, to try and control « irrational exuberance ». Wall Street is complaining that the FED is selling the market! Truth is that Wall Street is hooked on cheap money and does not like the idea of getting back to normal interest conditions.
A survey of professional investors indicated they are allocating nothing into the US markets. The same survey showed that they are putting funds into Europe and Emerging Markets. We are also doing that.
So at present it is a mixed bag of indications from the USA and much will depend on the future earnings trend. The proposed corporate tax reductions are critical to maintain the current earnings anticipations and if the proposals do not go through and the government spending plans are much delayed, or vetoed, the effect on stock market valuations will be profound. Just how much further growth is there in the US markets? What applies to the US markets also applies to the South American markets, since if there is any weakness in the USA, Americans repatriate their funds.
Now we come to Brexit and Europe. Well the negotiations have started and already May is on the back foot. The Europeans have insisted that the Brexit bill is agreed and the status of EU citizens in the UK is settled, and that has been accepted by the UK. The 2 years negotiation process starts, although nothing will be really be moved along until the Germans now decide what should happen. The UK team will naturally be pressing for results but the tighter the programme the more it is to the advantage of the Europeans since they hold most of the cards and the tone is currently not to accept any pressure from the UK. Naturally the media are having a field day on such a complex and contentious issue. There are many complicated issues to resolve which will demand hard negotiations and time. The UK team is under-manned for such arduous all night sessions, which will not help matters.
Leaving aside the political issues such as immigration, UK and EU citizens living in each other’s territories, aviation, security and defence etc , I will try to assess the economic prospects for both groups. Some of the predictions are inevitably affected by the « political » issues but the most important economic issues are as follows :
The £/€/USD exchange rates. I predicted in June 2016 that the £ would slip to US 1.20 to the £. Well today it stands at USD 1.31 having taken a beating over the last few months. It could slip further. The € is standing at € 1.11 to the £ and stood at € 1.31 on 22/06/16. These drops are indicative of what the international financial markets think of the Brexit decision and the likely trade outcome. The Leavers are saying it is good for exports. But they forget the impact of the higher cost of imports coming through the supply chain. Devaluation is a short term palliative which seldom works and has certainly not done so in the UK. Many people under-estimate the effect of trade on the currency rate. The higher the exports and the lower the imports the higher the currency goes because it is in demand.
The import / export relationship is important because today Europe is the UK’s biggest trading partner. The Leavers forget that geographical proximity is one of the most important economic driving forces. How that is going to evolve under Brexit is not completely clear but one thing is certain and that is the UK Government and Business will have to adapt drastically. One is reminded of when the UK joined the EU and the effect it had on Australia and New Zealand. Well, they had to adapt and it took time, but they did and now today they are prosperous and have no economic need of the UK. That is not forgotten to this day by the Aussies and Kiwis and they have directed their economies to countries geographically closer to them. Where is the UK going to direct itself geographically?
Tariffs and cross border taxes. This is going to be a complicated bun fight between the UK and Europe. The more tariffs, cross border taxes and VAT there are the more both parties are going to suffer. We can only hope that common sense based on common interests will prevail.
The Current-Account balance is already showing signs of strain for the UK. The balance is a deficit of minus 138.1 billion USD over the last year. Only one country exceeds that figure and that is the USA. The Euro area had a POSITIVE balance of 392.3 billion USD, mainly contributed by Germany. Who says that the German economy needs the UK? The Germans will adapt to Brexit faster than the UK. The rest of the Euro area was in positive territory except France at a deficit of 34.5 billion USD. This partly explains the relative strength of the €. Provided the Germans and the Italians do not step into the Populist political arena ( with their disruptive economic policies ) the EU and the € will continue their comparative strength. The German elections have restored confidence but the extreme Right now have to be contended with. Clearly Merkel will not win the next election and so there is going to be a lot of jostling in the German political arena in the next few years. Meantime Macron and Merkel can get on with improving the EU.
Cross border taxation could be a potentially difficult area but the UK has extensive Double Tax Treaties in force, including with EU countries, which will stand and therefore mitigate any damage. The UK has already enacted and practices under the FACTA and CRS exchange of information policies and that will not change. The one area that the Europeans are concerned about is if the UK becomes a low corporate tax country in a race to the bottom. In other words the UK will become an offshore area in Europe. Well, Luxembourg has already swung the lead on that one and will be reluctant to see the UK take over that role. It could become part of the negotiating stance by the UK so that the City and the European trade from it continue. Luxembourg has slipped neatly into the EU on that basis but is now under pressure because of the EU initiative to obtain a level playing field in European taxes. However Luxembourg, Eire and Malta, are sticking to their guns on their entry terms and the European Court of Justice has been of assistance to them. The European bureaucrats are not going to find the implementation of the Anti-Tax Avoidance Directives 1 and 2 so easy to implement, particularly with the British who have their own version of ATAD!
There has been much talk about damage to the City, but for currency exchange it seems that the vast and efficient technology that has been put in place between New York, London and Germany is not really going to be threatened. Where the City can suffer is the right to passport into the EU, which has meant that both UK and US financial houses have been able to profit from the freedom. It seems that the City will lose some business and the French, Dutch, Irish and Germans are all looking at the possible fallout from the City and the potential moves away from London. The French for example are going to build 7 skyscrapers in the Paris financial area, together with a massive new transportation system, including the suburbs, which will make it possible to get from one area to another with even greater ease. The Euro exchange trade out of London is targeted for attack.
There is the divorce bill of some 60 to 65 billion euros that the EU is demanding even before conceding any terms. The leavers have come up with the stupid expression – no deal is better than a bad deal. No deal will mean that the UK will steadily slip into an estimated minus 7.5% GDP growth. In other words become a third world country. It may have to be bailed out by the IMF! However, May has conceded that the exit bill is to be negotiated and paid.
So it is little surprise that the UK economic pundits are in confusion about the future GDP growth of the UK and are predicting between 0.7% and 1.7% for next year.
Europe is going through a potential political upheaval with threatened populist movements, but business is picking up and the Germans and the ECB are holding a steady course. The election of Macron as the next French President has been welcomed all round. Although he has the majority in the Assemblé and the Senat the extreme Left have formed a group and can, and will be, a profound nuisance on the streets. If Macron sticks to his policies and carries the majority with him, he will go down in French history.
Of course there will still be concerns about Italy. The Greeks came back with their begging bowl and have had a « donation » so that issue has been shelved for the time being.
The emerging country markets have been picking up well and so have their currencies, but that was probably to be expected after having fallen out of favour with international investors.
China and India are still doing well and their rates of growth make some developed countries look at them in envy. Both countries have infrastructure and social problems but they are being addressed.
To under-estimate China and India and their investment potential over the medium and longer term, would be a great mistake.
Geoff Heywood 8/10/2017