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Geopolitics re-enter market stage

10 May 2019

Just as markets were trying to prove that they have regained some rational balance when they shrugged off central banks’ rejection of further monetary support, geopolitical tensions returned with vengeance. Perhaps it was naïve of the international investment community to assume (and price into their market valuation metrics) that the US and China would imminently reach a trade agreement, simply because it is widely accepted wisdom that trade wars have no winners.

It is still hard to gauge whether it was brinkmanship on the Chinese side, too much pressure from Trump or internal disagreements on both sides which led to the breakdown in the negotiations. In any case, the week began with some threatening Trump tweets and ended with a massive further hike of US trade tariffs on imports from China and no dates for further negotiations. However, just as the week before, markets reacted far more sanguinely than most strategists would have imagined to the prospect of serious negative consequences for the world’s two largest economies.

Admittedly, stock markets have lost between 2 and 3% over the course of the week, but that is certainly not pricing in the fact that the tariffs will be around for long enough to actually bite. What is more, they were happy to recover considerable earlier losses in Friday late trading in reaction to the slightest of hints by the US administration of trade optimism. This is remarkable, given it was not just the US-Sino trade war that increased the geopolitical risk  barometer: Venezuela (an oil giant of days past) is descending ever faster into civil war, North Korea’s “rocket man” has resumed his test launches, and Iran’s economy and its moderate politicians are coming under ever increasing pressure from the Trump administration, who are threatening military intervention should they find Iran is undermining US interests and undermining their own allies with sanctions should they dare to continue buying Iranian oil.

This relative market calm cannot be attributed to another round of splendid corporate earnings results. The Q1 earnings announcements are in aggregate just about delivering a positive single digit growth rate and a no-better-than-neutral outlook by company managements. The uninitiated observer would be excused for taking this as a formidable decline and a disappointment after last year’s double-digit profit growth and very upbeat outlook statements.

What is most likely keeping markets from descending into panic is a disbelief, on the one hand, that the trade negotiations will come to naught within the three week grace period until new tariff rates kick in. On the other hand, there is now a growing belief that the rising geopolitical tensions will make it even less likely that central banks will dare to raise interest rates and allow corporate financing burdens to rise any time soon.

In the absence of renewed earnings growth, market prospects are once again uncomfortably dependent on global monetary policy. As we experienced so painfully last year, this is not a stable foundation for sustainable increases in market valuations and can drive markets down as quickly as up.

For the coming weeks, this opens up the prospect of another rally, at least recovering last week’s losses. But this very much depends on the future course of not just the US-China trade negotiations but also Middle Eastern tensions, not to forget North Korea and Venezuela. Over the medium term, we will have to watch closely whether the tariff and oil price-induced inflation will indeed prove transitory or will force central banks once again to fear (and counter) inflationary pressures like last year.

The UK’s continued total preoccupation with Brexit is far less likely to play part without looming deadlines However the same cannot be said about the Europewide elections to the European Parliament. The anticipated gains by more populist and extremist political forces on either side of the political divide – almost everywhere in Europe- will probably either lead to more unconstructive political instability or will force a more constructive adjustment of political positions, encouraging more cohesion between the recently not so unified peoples of Europe.

We will refrain this week from any suggestions of imminent market or currency movements. But we would like to point out that currency markets did come to their senses as quickly as we had suggested. The €-Euro has regained ground against $-Sterling, as it has become more widely accepted that the UK’s uncompromising Leave and Remain camps have established a majority over moderate political forces in the UK which will make it most unlikely that any Brexit compromise can be passed by Parliament. This makes another referendum almost inevitable and thereby the necessity of a further Brexit extension beyond October most likely. Uncertainty is therefore bound to continue, while the only absolute certainty has become that UK society will remain deeply divided for many years to come. And that is true whatever the outcome of the next plebiscite might be.