International Tax, Impact Investing, Structured products, ETFs, Private Equity, Planning
NEWSLETTER MARCH 2018
2018 – So far…
After a remarkable 2017, in the 1st quarter of 2018 we have seen volatility return to the markets. Stock markets had forged ahead in 2017 with low volatility and even bond markets were steady in spite of slowly rising interest rates.
The trigger for the reaction in markets was the increase in US wage rates and slight increase in inflation. That was enough for markets to assume continuing increase in interest rates by the FED, probably 4 rises in 2018 each of ¼%. Volatility jumped and there was a general sell off.
For the quarter the S & P 500 has dropped 8.4% since the peak in January, the Dow Jones down by 5.0%. Conversely gold is up 5.0% and oil is steady at $ 64.9 for WTA and $ 69.53 for Brent. The FTSE 100 is down 7.7% from its peak and the HK Hang Seng 9.2%. Market exuberance seems at first sight to have run its course, although as one trader from the NYSE Floor said “ This is still a market that is trying to go up” Well, increased earnings and trade growth have been pretty well global, but the Baltic Dry Index is off 14.2% since it hit a 4 year high at 31/12/2017, which is indicative of a future slowing in shipping. This could be hesitation in view of Trump’s aggressive behavior on tariffs and world trade. Of course Trump always starts out with outrageous statements which are then modified in line with advice he receives. He maintains that it is all part of his negotiating tactics and can then boast that he is sticking to his America First policy and take credit for matters achieved. However since no one knows exactly what the outcomes are confidence is eroded.
The background to these movements is as follows:
The most important is the USA. Trump and his administration have at last obtained legislation in Congress and the House of Representatives to bring in radical tax reform. He urgently addressed tax reductions so as to kick start the economy and boost corporate earnings – since it was not obvious where further growth was going to come from. On this subject he had more encouragement from the Democrats and so was able to push through the legislation. It was not all that he intended but certainly provided a boost to confidence. However, it is not as balanced as some would like since the benefits are more inclined towards big business than smaller businesses with only a modest gain for households. It certainly has proven popular with big business and it has been said that Trump and his billionaire friends have been the sort of main beneficiaries. How that pans out at the mid-term elections remains to be seen…Even if he loses the House by a slim margin he will still be able to pursue his programme. So all in all I think we will still see further Trumpism in 2018.
The US 2018 Budget passed a good deal easier than anticipated with an approval for 1.3 trillion USD increased spending with programmes such as military spending, infrastructure and the Mexican Wall all able to get started. Such programmes spread out over several years, but it has increased confidence in certain market segments. US stock markets rose to historic highs with an average P/E ratio of 26.30 at the end of January, with a mean going back to 1880 of 15.65. The current ratio of 24.67 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 VIX volatility index hit 10.08 at the end of December, which was historically quite calm. However the VIX jumped in February to 37.7 then fell back rapidly so that at the end of March it stands at 19.9. The VIX has hit temporary spikes like this before, and higher. October 2008 for example saw 80.86.The trend line on the VIX seems to be a downward triangle since the spike. That could mean an eventual upward break or a steadying into calmer waters. The Relative Strength Indicator ( RSI ) S & P 500 was at 60.62 at 31/12/17, and at 29/3/18 it was at 30.60 . 30 and below indicates an over-sold position. Maybe the trader on the NYSE floor has got the right feel for the market. The RSI hit a peak of 79.93 in 2017, which was an over-bought signal and a reaction followed. 60 to 70 is an over-bought signal.
In the December Newsletter I said:
“To my mind the indices which need watching are the unemployment rate at 4.1% in November 2017 and inflation. 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 and the 4.1% is the lowest since February 2001. The inflation rate is at its highest since 2012 and been 2% and over since December 2016. The projection for 2017 is 2.65% and estimated at 2.38% for 2018. The projections are that US CPI inflation will be over 2% for the next 5 years. 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 rate conditions. The unemployment rate for February 2018 was unchanged at 4.1%. This could well be the clue as to market behaviour in 2018.
In September 2017 a survey of professional investors indicated they were allocating nothing into the US markets. The same survey showed that they are putting funds into Europe and Emerging Markets. We also did that, to good effect.
Now we come to Brexit and Europe. Well the negotiations are ongoing and May is on the back foot. The Europeans have insisted that the Brexit bill is agreed, the Irish border situation is resolved and the status of EU citizens in the UK is settled with reciprocity for UK citizens in the EU. All 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 not to accept any undue 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. The EU have now agreed to a lengthening from 2019 to 2021 for the final agreements to be reached and the UK exits from the EU.
As one EU Official put it – The UK wanted to join, with conditions, and now it wants to leave with conditions!
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 1.40 as the US dollar has weakened short term. The pound looks as though it could slip further in the next two years. The € is standing at € 1.14 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. There is going to be complicated in-fighting 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 €. The Germans have not stepped into the Populist arena and now all eyes are on the Italians after their elections. If they 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 on 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, 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 and the EU countries are determined that it be brought to Europe once Brexit is achieved.
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 and her government have conceded that the exit bill is to be negotiated and paid, and the figure now being discussed is in the region of 40 to 50 billion euros. This is still significant and will take several years for the UK economy to absorb. The current level of world trade will help the UK.
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 2018.
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 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. So far so good in 2017 and 2018 is looking more positive for France.
Of course there will still be concerns about Italy after their elections. Who is really going to govern Italy? The situation is still not resolved. 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. Recovery in the emerging economies in 2018 is likely with a growth rate of over 5%, which includes Russia and Brazil.
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. Trump’s China attitude is going to give some “trade war” rhetoric and it will be interesting to see how much is noise and how much is action. Either way China’s growth will be at about 6.5% for 2018. The IMF is predicting a growth rate in India for 2017/2018 of 6.7%.
To under-estimate China and India and their investment potential over the medium and longer term, would be a great mistake.
Geoff Heywood 02/4/2018
Geoffrey Heywood provides regular financial reports and updates. Client investors receive timely market information and are so informed on the trends and their investments