Political tensions = economic risks

Investment Policy, December 2018

Political tensions = economic risks

The continued high volatility in equity markets, which are normally buoyant in December, is attributable to a further increase in political risk. Trump's ceasefire was short-lived. The current message from the market is clear: With the increase in political tensions, the economic risks are now rising globally too. 

From the macroeconomic perspective, the latest developments read similarly to the political narrative – increasing fluctuations due to rising tensions. In a normal year, the shorter days of December tend to put markets in anything but a bleak mood – festive cheer is typically the norm. But the dark clouds of geopolitical events have unfortunately prevented this pattern from asserting itself again in 2018. The latest example of this is the Huawei saga. Barely had US President Trump negotiated a "ceasefire" with China – in other words, no further escalation of the trade war for 90 days – than the CFO and daughter of the founder of key global Chinese technology company Huawei was accused of violating US sanctions against Iran. Not surprisingly, the financial markets perceived this development as evidence of a renewed deterioration in relations between the US and China, and accordingly reacted by factoring in a higher risk premium through equity valuation reductions (and therefore lower equity prices). The economic risk now is that the longer such political tensions persist, the more the global economy may suffer from the related uncertainties – for example by companies postponing planned investments. Indeed, this is already apparent in weaker year-on-year industrial order growth in Germany, and to a lesser extent also in the US. 

The longer the political tensions the greater the uncertainties, the more and the more reduced global economic growth of the next quarters.

Gérard Piasko, Chief Investment Officer

For the equity markets, these increasing political uncertainties mean that any manifestation of the traditional year-end rally is being quickly sold by many market participants, i.e. any rise in prices is being used to scale back equity exposure. At around +1.5%, December is historically the best month of the year for the S&P 500 according to Bloomberg (data since 1950), yet the political environment and its architect-in-chief Trump are making this difficult – if not impossible – in 2018. 
Over in France, the popular protests that have dragged on for several weeks are having a negative impact on traditional Christmas shopping volumes. It is therefore only logical to expect a slowdown in economic growth in France, as Christmas business has long been crucial to the retailing sector, and consumer spending is the key driver of economic development in France too. Meanwhile, Germany is feeling the effects of a decline in manufacturing momentum, and Italy is struggling with a sharp deterioration in corporate sentiment, which is close to pushing the country into recession.

All around the world, the economic consequences of the trade conflict are becoming increasingly apparent. For example, export activity has declined significantly in recent weeks in both the Eurozone and China. Neither Chinese nor European industrial production figures have impressed recently. In all likelihood, this will have a negative impact on earnings growth over the next few quarters.

Two factors are currently holding sway in the fixed income market. On the one hand, inflationary expectations have been reined in, which has caused the yields on government bonds to fall since mid-November. This is a consequence of the decline in global energy prices. 
On the other hand, the rise in yields on corporate bonds compared to those of sovereign bonds has emerged as an incipient global trend. This phenomenon initially manifested itself in the Eurozone, and was attributable to the corresponding political uncertainties – including the Italian budget dispute and ongoing Brexit saga. This so-called widening of credit spreads has now also reached the US, where it is dependent on corporate earnings. Lower earnings growth could drag down the prices of corporate bonds against a backdrop of economic weakness. 
As the yields on US government bonds have declined, so too has the upward march of the US dollar been stymied again. This has enabled the currencies of the emerging markets to stage something of a recovery. Viewed in fundamental terms, most of these currencies are not lavishly valued. However, any renewed escalation of the trade conflict between the US and China would weigh on the Chinese currency. The Chinese government could counter any further round of tariff increases on the part of the US by tolerating a 5-10% devaluation of the yuan, although this could have the knock-on effect of putting other Asian currencies under pressure in order to prevent them being disadvantaged vis-a-vis China in the export market. 
EUR/USD is currently oscillating in a technical trading range of around 1.1250–1.1550. Viewed from a technical perspective, the next resistance level for the euro lies at around 1.18, and this could be tested by any progress in the discussion between Italy and the EU over the former's proposed budget deficit. However, any failure to reach agreement and a further weakening of economic growth in the Eurozone can be expected to push the value of the euro against the dollar down toward the 1.12–1.10 level. This would also have negative repercussions for the euro against the Swiss franc, which could then fall below 1.10.

The development of commodity prices is not just dependent on the development of supply, even though this aspect has been increasingly the focus of debate recently. A possible weakening in global demand for oil over the course of 2019 due to slowing global economic growth should also be factored into calculations. In other words, the volatility of the commodities asset class generally – which is already high when viewed in historical terms – and the oil price in particular could persist over the next few weeks and months. The result of the most recent (semi-annual) OPEC meeting, namely to reduce the supply of oil by more than 1% of global production, is hardly likely to bring about any lasting reduction in the notoriously high fluctuation of the oil price. Why not? No specific production targets were negotiated for the individual OPEC countries, while Libya, Venezuela and Iran were exempted from the supply cuts altogether.

A medium-term gold allocation appeals at the moment with a view to reducing the overall volatility of a mixed portfolio. True, the price of gold will continue to be strong-ly affected by the performance of the greenback, but gold has proved its value as a tool of diversification on many occasions in the past against a backdrop of escalating geopolitical tensions.

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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Editorial deadline: 28 December 2018

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