New article from Tatton Investment Management: It is getting hot

6 July 2018

It was a week with two faces – strong economic data across the developed world on the one side and disruptive political rhetoric on the other. Donald Trump’s administration imposed tariffs of 25% on $34 billion worth of Chinese imports and China retaliated in kind. At these volumes, the tariffs are currently not expected to have materially negative consequences to the wider economy. But there is a widespread fear that they are only the opening salvo to a tit-for-tat trade war that would have no winners. It is perhaps this generally accepted insight which has had markets remain surprisingly calm, even when it is entirely unclear how the Trump administration will progress towards negotiations which are neither scheduled yet nor their objectives agreed by a deeply divided team under Trump.

This will sound uncomfortably familiar to our UK audience, who face similar uncertainties over the direction of Brexit. However, at least the UK’s Prime Minister appears keen to avert harm from the UK’s economy and unite her cabinet behind a comprehensive negotiating strategy – even if that means that she might have to lose some of her most dogmatic cabinet members.

As deeply unpleasant as all this divisiveness around the world may be, there are feeble signs of movement here or there. The European car industry signalled that they are not particularly wedded to the EU import tariffs on US cars, which found German chancellor Angela Merkel’s support. She also noted during a visit by Theresa May that Brussels’ negotiating approach was perhaps not pragmatic enough to secure a mutually beneficial end result.

Stock markets took the political noise in their stride and posted a mildly positive week. Given Trump’s trade war politics and Brexit negotiations are highly unpredictable, and have little influence over the shorter term corporate earnings and the Global economy at large, there was more focus on future interest rate movements, changes in the cost of capital around the world and the likely rate of corporate earnings growth for the past quarter.

The asset class returns table at the top shows that, despite the pronounced return of market volatility during the first 6 months of the year, returns overall are broadly positive. That US stock market returns are leading others has much to do with the strengthening of the US$, driven by the repatriation of large volumes of US multinationals’ overseas earnings in the wake of the tax reform. This appears to have also provided a boost to US stocks, as many of the tech companies elected to use some of the cash to buy back shares.

While such effects cannot last, the positive momentum of the US economy is far more likely to carry on into the second half of the year. Similarly, the latest updates from across Europe suggest that the distinct economic slowdown in the first quarter of the year was only temporary and either a counter-reaction to overheating in Q4 2017 or weather and sickness related – but most likely a combination of both. This paints a more positive picture for the economic environment during the second half of the year (H2 2018) than we had dared to predict at the end of last year, when it had seemed that economic conditions would possibly overheat in H1 and then decline in H2.

Unfortunately, that doesn’t mean we should expect investment returns to pick up their pace from the fairly pedestrian levels we’ve seen so far. While improving corporate profits would normally be expected to see markets trend upwards, this could be disrupted by a number of things: higher costs of capital through rate rises, the reversal of QE and the prospect of Trump’s deliberate disruption to global trade flows. In such a scenario, investors are less willing to project current earnings conditions into the future, which results at least in a temporary ceiling to market levels and at worst increased levels of volatility, as every piece of news is scrutinised for the medium term impact it might have on the future direction of the economy.

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