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29 March 2019 – quarter end

1 April 2019

The vexed date has come and gone, as we had suggested, but not quite in the manner we had expected. While the population widely blames Parliament and the political class in general for the Brexit execution debacle, MPs are just as divided as the entire nation over the UK’s 2016 decision to quit the European Union. The consequence is that as the number of possible options for an orderly exitrapidly reduces day by day, as the ‘overtime’ required to solve the impasse through an extension has increased substantially over the course of the week.

This is frustrating and costly for all who were expecting the return of some level of planning certainty, particularly the business community. But it probably reflects fairly on what is at stake for the nation and how passionate so many people feel about it.

Observing the news media coverage across Continental Europe and the US and comparing to that in the UK, it is striking that the British press appears to expect a softer Brexit by the day. Whereas, the foreign press (and politicians for that matter) interpret British politicians’ indecisiveness and running down of the clock as a sure sign of a no-deal outcome becoming ever more probable.

We would side with the UK press and continue to find support for this view in the reaction and state of financial markets. Risk asset markets around the world – including the UK – closed the week higher and even the value of £-Sterling hardly budged following the third and probably final defeat of the government’s withdrawal treaty by Parliament. The market’s quarter end marker was non-postponeable beyond 29 Mar 2019 and the results tally delivered a remarkable reversal of the last quarter of 2018. Stock markets around the world posted healthy gains of up to 10% and thereby very nearly recovered the previous quarter’s losses. With bonds having rallied as well, corporate debtors are feeling relieved, after rising costs of debt caused pressure last year.

Remarkably, the financial analyst community seems similarly divided over whether the falling bond yields are a positive or negative signal for the 2019 development path of the global economy – as the UK is over its Brexit path. Many economists see it as a credit stimulus for the economy and expect a re-acceleration after the recent global slowdown. On the other hand, many investment strategists interpret it as the bond markets (once again) calling the end of this drawn-out economic cycle.

Unfortunately, at this point the jury is out. Much will hinge on sentiment swings of consumers and businesses. In China sentiment remains on an upswing, as we point out and comment on in a separate article this week. Europe is at the other end of the spectrum, as it still suffers from 2018’s decline in global trade and recent Brexit angst. The US is somewhere in between, with declining sentiment readings from very elevated levels as last year’s fiscal sugar rush is waning, and the prolonged government shut down and unresolved trade war with China have begun to take their toll.

In our assessment, the current juncture has many similarities with the aftermath of the previous market corrections that followed temporary economic slowdowns in 2013 and 2015/2016. In both instances, the easing of credit market tensions together with fiscal counter measures by China proved sufficient to stabilise the global economy and put it back on the growth path.

It seems likely that the same will happen again over the coming quarters, perhaps further helped by a no longer strengthening US$. However, history only rhymes but rarely repeats and so there are risks and opportunities in our central case. The political outcomes of Trump’s trade war and Brexit are one set of crucial variables; central bank policy and an orderly credit market are the other.

As noted, we are more optimistic than pessimistic about the political side. It seems likely that positive political outcomes will cause a catch-up in demand, which should make up for the damage that has already been done. On the credit market side, we have to concede that vulnerabilities to the world economy from the next credit default cycle are much larger than they have been historically. This is a consequence of the much higher levels of debt, rather than equity finance volumes that the past decade of ultra-low interest rates has led to. Central banks were and are aware that their extraordinary monetary measures would cause this negative side effect. That is why central bank policy has been so much more reactive to moves in credit markets than would otherwise be the case.

Unfortunately, the over-selling in markets last year shows they are scared of the size of the credit market and the risks it brings too. This means that while central banks are determined to defuse the credit market risk over time through gradual normalisation of their monetary policy, they will from time to time overshoot their targets as they manoeuvre in uncharted territory – as happened last year. Volatility episodes like the last two quarters are therefore likely to repeat. And with every setback, the time to normalisation extends into the future. This shorter-term cyclicality has the potential to perpetuate the ongoing prolonged cycle much further than previous cycles. However, it is equally possible that a future bout of volatility causes irreparable damage and the ensuing mass corporate defaults lead to a global recession on a par with the Global Financial Crisis (GFC).

To close on a positive, banks are today far better capitalised as a consequence of the GFC and it is therefore less likely that we will once again be faced with a near collapse of the financial system.