Author: Alastair George
Doveish comments from a number of US Fed policymakers in recent days have validated a very sharp decline in US interest rate expectations. In response to these comments, US equities have also rallied. It is hardly a surprise that the US Fed would respond to lower growth and inflation prospects with easier policy. However, while bond markets are correctly in our view discounting lower prospective interest rates, equity investors should also factor in lower profits expectations for 2019 as the effects of the trade war bite. It also makes us uneasy from a longer-term perspective to see monetary policy used to counter the self-inflicted harm from an arguably sub-optimal US policy on trade.
The seemingly quaint concept of moral hazard, in which bail-outs incentivise further risk taking, may now have reached the political domain. For the banking sector, central banks addressed moral hazard with an enormous global effort to reduce bank sector risk and improve resilience in the form of increased capital buffers and supervision. Furthermore, new macro-prudential regulation enables regulators to rein-in excess lending should the need arise. Central banks may have offered bail-outs, but at least they tried to collar the banking system for the future.
In contrast, in the political domain we are seeing increased levels of risk-taking in terms of policy, with no obvious mechanism for restraint or correction, other than periodic elections in developed markets. This risk-taking is correlated to the sharp rise in policy uncertainty indices seen in recent years. Such policies include the US/China economic dispute, Brexit and Italexit. US/China may be the single largest dispute but the current US administration has also engaged historical allies in a significant trade confrontation.
It could well be argued that Fed policymakers are only following their technical mandate of promoting price stability and full employment by countering a US trade policy-led slowdown. It could also be argued however that by allowing monetary policy to absorb the negative short-term shock this may enable the US trade conflict to continue for substantially longer than it might otherwise.
We suspect long-term equity investors would prefer to see a shift back to a US presumption of the benefits of global free-trade policies, as unlikely as this may be at this point, rather than another short-term palliative in form of lower interest rates. For this reason the bounce in US equity markets is unlikely to represent the start of a bullish trend in our view.
Followed to its ultimate conclusion, the US policy of using tariffs to improve its terms of trade are likely to prove damaging to the global economy. US policy also ignores the experience of Europe, in the quiet progress achieved in terms of common standards of product, production and limits on state support. These have lowered the risks of unfair competition and all within the confines of a tariff-free common market.
The institution of the EU can be criticised in other regards, but during the Brexit process it is evident the common market has significant value to all parties. If the US had engaged in a low-profile but sophisticated technical approach to ensuring fair competition in return for access to US markets, it may in our view have had a better chance of success achieving its strategic objectives, and with fewer risks to the economy.
US trade policy also carries the risk that China and the EU may take the opportunity to develop regional champions especially in newer technologies where the US has historically had a large lead. For example, European proposals for digital taxes, which would be largely borne by the US technology sector, are likely to be easier to implement in an environment of trade tariffs. Increased taxes, combined with the inefficiency of a fragmented global market and the resulting improved negotiating position of labour would be likely to pressure corporate profit margins over the longer-term.
Our more positive views on global equities earlier this year were driven by a belief that the US/China trade conflict would be resolved by mid-year, with an eye to the US Presidential election in 2020. Since then, the parties’ positions have become entrenched and the negative economic effects in terms of slowing trade and survey data have become clearer.
Slower growth and inflation is now correctly embedded in short- and long-term interest rate markets. The recent confirmation that the US Fed will respond to a weakening economy may offer a brief respite to equity markets (and we expect the ECB to follow suit) but are hardly a surprise and in the worst case may delay any resolution to the US/China conflict by insulating politicians from the costs. We therefore remain cautious on global equities at current valuations.