On October 4, we provided a brief summary of the Brexit negotiations -- the talks between the UK and the European Union over how the UK will depart the EU, following a referendum of its citizens in 2016. Brexit fears have been one psychological driver of the current correction and have contributed to the markets’ grim assessment about weakening global growth prospects in 2019. There has even been nebulous fear that unforeseen Brexit consequences could result in a crisis and a recession.
As we have often written, we are ultimately bullish on the UK should it manage a Brexit worthy of the name -- i.e., a Brexit that does not oblige the UK to continue to observe most of the EU rules the British thought they were rejecting. It remains to be seen if that will be achieved. In the meantime, though, the psychological significance of the Brexit process means that market participants navigating the current correction should stay abreast of current developments.
Where Do Things Stand?
Last week, two and half years after the UK vote that started the process, UK Prime Minister Teresa May handed her cabinet ministers a 585-page document agreed on between the UK negotiators and their EU counterparts. It prompted two immediate resignations -- including the resignation of Dominic Raab, the minister who had been overseeing the negotiations. But mostly, her cabinet backed the proposed deal.
What exactly is this deal? Given how difficult it’s been to reach, and how long it is, you’d be forgiven for thinking that it was the final, complete agreement for the future relationship between the UK and the EU. It isn’t. It’s simply the “separation agreement” -- not an agreement about future relations. It has three parts: a financial settlement (to cover the UK’s outstanding financial commitments to the EU), an agreement on the rights of European citizens in the UK, and UK citizens in the EU; and a mechanism to prevent a “hard border” with customs checks on the island of Ireland (i.e., between Northern Ireland, governed by the UK, and the Republic of Ireland).
Almost all of the trouble has come with that last piece -- figuring out how the UK can leave the EU’s customs union, and still have no need for border and customs checks between Northern Ireland and the Republic.
This arcane issue is sticky because of Ireland’s fraught history, and the insistence of Northern Irish loyalists in May’s government that Northern Ireland not be treated differently from the rest of the UK -- and that the North not be unduly separated from the Republic. The stability of May’s government depends on a Northern Irish political party, the DUP. So the draft agreement includes ALL of the UK in a customs union with the EU -- and for the EU, that in turn means that the UK has to abide by a swath of EU rules on state aid, competition, the environment, labor conditions, and so on. This is exactly what the pro-Brexit camp did not want to see.
So for various reasons, there are many, many British politicians -- Conservatives, Labor, and others -- who vehemently dislike the deal that’s being proposed to them. After EU member states sign off on the deal in late November, the British Parliament will have to vote on it, probably in early December, and this will constitute the biggest test of Teresa May’s career. The parliamentary math is difficult and uncertain -- in other words, it is far from obvious that the proposed deal will get approved.
Where Are Things Headed?
So what are the possible outcomes in the near future? We see several.
First, the draft agreement might be approved by the UK Parliament. This would be the most calming event for market psychology. It would also give great relief to UK and EU businesses.
Second, the draft agreement might be rejected. If it is, the Prime Minister has 21 days to put forward a new plan. However, in the meantime, this could trigger a vote of no confidence from her own parliamentarians, and then a new Prime Minister would need to be selected from among their ranks. Another kind of no confidence vote, from parliament as a whole, could trigger snap elections, which under current polling would be likely to bring a Labor government to power. Since the Labor Party is currently headed by hard-left socialist Jeremy Corbyn, this is not anything that Conservatives would want to risk -- and so is unlikely. The defeat of the proposed deal in Parliament would lead to significant volatility and anxiety.
Third, Prime Minister May could withdraw the current agreement before a vote, to try to renegotiate, if it looks certain to be rejected. This would create less turbulence than a loss, but it also might trigger a Conservative leadership crisis or a push for snap elections. The EU negotiators are also likely to be uncooperative; they’ve been publicizing this as a “take it or leave it” offer.
Fourth, in the face of likely parliamentary defeat, May could ask the EU for an extension. This would be problematic, because of the tough stance taken by many EU members who wouldn’t want to cut the UK any slack. Some of them are battling political factions in their own countries who advocate ditching the Union -- and they don’t want to make the process look pretty or easy.
Market Summary
The U.S. Economy
The U.S. economy continues to be strong, while moderating a bit at the edges. We expect GDP growth of about 2.9% for the fourth quarter of 2018, which will create a 3%-plus year -- but next year’s growth is the question. Many are saying that GDP growth will fall to a rate below 2% by the end of next year. We don’t see that currently in the picture. Taken alone, U.S. GDP growth should be over 2.5% next year. However, this is a deceleration from GDP growth of well over 3% in 2018, and so is viewed by some as a negative. If GDP can maintain a sustainable rate in excess of 2%, this will be good for the economy, the stock market, and the wealth of the American public. Of course, the U.S. economy operates as part of the world economy, and thus is affected by problems that have appeared in Europe around Brexit and the Italian budget. A negative outcome for these could cause a further decline in U.S. economy, and positive news on these could improve the outlook for the U.S. economy.
U.S. Stocks
The U.S. stock market has had a well-documented decline of about 10-11%, while some faster growing sectors have had a much bigger correction -- such big tech leaders (the so called FAANG stocks), and high-earnings-multiple growth stocks in the cloud and biotech sectors. Under the surface the market has declined substantially, with 40% of S&P stocks correcting by 20% or more.
This has frightened many observers into saying that the market is discounting a U.S. recession coming in 2019. We are hard-pressed to see economic evidence of a U.S. recession in 2019. Neither do we see a global recession bleeding into the U.S. in 2019 which could cause a U.S. recession by damaging our trading partners or the world banking system. Thus we believe that the current reaction in the market is due to:
1. Fears that too many interest rates increases by the Federal Reserve in 2019 could cause a U.S. recession soon beyond 2020. We realize that this fear is rampant, but it is not supported by economic facts.
2. Fears that the current economic slowdown in China will spread to the rest of the world due to the trade conflict with the US and other nations.
On the first point, we believe that these interest rate fears will be quelled as a result of comments by several members of the Federal Reserve in the last two days. Several of them have said that the Fed would be data dependent, and not continue to raise rates without closely monitoring if the economy was weakening. These comments should reduce fears that the Fed is not data dependent. These fears of irrational interest rate increases without economic justification have been widely circulated in the media. Clearly, these recent statements by Federal Reserve members do re-establish the fact that the Fed will be data dependent and thus is much less likely to create a recession by raising interest rates excessively.
On the second point, China has announced several measures, both monetary and fiscal, to boost credit and pump up housing prices. China’s main action to expand economic activity is to increase the availability of credit to stimulate housing prices. They took their first major steps in this regard about a month ago. Historically, when actions like these are taken in China, they are reflected in the economy about nine months later. We expect Chinese GDP growth to rebound in mid-2019 as a result of these policy changes.
Regarding 2019 recession fears, we do not see a U.S. or world recession in 2019, and believe predictions of a recession in 2019 are incorrect.
However, as we have said for many months, the world will go into a recession sometime in the next few years after 2019. The recession will probably be centered outside the U.S. Two possible sources of eventual problems are China’s over-levered financial system and Europe’s weak southern periphery as centers of banking weakness that could lead to the next recession.
In summary, during the period of stock market correction, we have moved out of over-priced sectors and increased cash holdings. We are always looking for new areas of opportunity, and holding cash will allow us to easily take advantage of them as they arise.
Europe
Europe’s weak banking system, which was not restructured after the crisis of 2007 and later, remains a big concern of ours. We are not optimistic about the prospects of Europe as an investment destination. The fight over Brexit and the looming immigration problem also diminish Europe’s attractiveness in our view -- even after Europe’s poor performance in 2018, which, as measured by the FTSE Europe ETF, is down 14% thus far in U.S. dollar terms in 2018.
Emerging Markets and China
China is a developed market that sets the tune for many South East Asian emerging markets to whom they outsource work. China is down 21% year to date, and although they have started to loosen their lending regime it will take a few months to reflect in the Chinese economy and stock market. China may become an attractive investment destination in coming months.
EM has also had a rough year, down 14.5% for the main emerging-markets ETF in 2018. Eastern European emerging markets have performed better. Latin American markets have been erratic, with Brazil rallying since their political environment has changed, but much of the rest of the continent doing poorly.
Gold
Gold is down about 8% this year. The two major drivers of gold -- which are inflation in developed countries, and instability in the world banking system -- have not been present, nor has the possibility of a major war. Although moderate inflation has been a problem in some gold-importing countries such as India, governments have been instituting rules to make gold importation expensive. A strong dollar has also weighed on the price of gold and other materials.
Cryptos
The crypto bear market continues. Besides the chilling effect we noted last week of an IMF endorsement of government-sponsored digital currencies, even many convinced crypto advocates are becoming convinced that price discovery in crypto markets has been significantly impeded by fraud and ill-dealing on the part of some exchanges. If the past is a guide, the current bear could last for months.
Market implications: Watch for the results of the UK Parliament’s vote on the proposed Brexit deal -- probably in early December. The results of that vote could have a significant effect on market psychology in Europe and in the U.S. The optimal outcome would be a win for the deal. A failure could cause further volatility -- especially if Teresa May’s leadership, or Conservative Party rule, come into question.