Brexit is providing one source of geopolitical risk on which investors can be more optimistic
The synchronised recovery, which proved so fertile for markets last year, is ongoing, with growth in the major economies – the US, eurozone, Japan and China – still above trend.
This is translating into robust corporate earnings. First quarter earnings beat expectations in the US and while it is early days, the second quarter looks similarly strong.
Economic activity has been broadening from consumer spending to corporate investment. The memories of the great recession took a long time to fade, and for many years corporates lacked the confidence to expand business investment. Although this has been a long recovery it has been a very shallow one, largely due to this hesitancy among corporates to invest.
Firms are being forced to spend more on capital as labour is becoming increasingly scarce, particularly in the US. Going forward, firms will have to squeeze more out of their existing employees; in other words, they will need to raise productivity.
Evidence of rising productivity would be a very positive development for markets because it has the potential to extend the cycle, keep inflation low (by reducing unit labour costs), support corporate profitability and limit the need for much higher interest rates. We are still waiting for the first estimate but US GDP growth in the second quarter may have been north of 4 per cent, which would suggest productivity is recovering.
Left alone, there is potential for this virtuous cycle of growing confidence, growing investment and growing productivity to flourish. But policy coming out of Washington is creating risks around the benign outlook.
The prospect of a global trade war is the most concerning. The US administration believes the large current account deficit in non-energy goods is a reflection of lopsided trade deals. So far, the only concrete action has been the introduction of tariffs on steel and aluminium entering the US.
These alone will have very little impact on either US or global activity. But the risk is these relatively minor actions escalate in a “tit-for-tat” manner to other products. The US is currently consulting over further tariffs on a broader range of goods imported from China as well as auto imports which would affect Europe significantly.
Our central expectation is that these skirmishes do not escalate into a full trade war. Although “cheap” imports challenge some sectors and workers in the US, the vast majority of US households benefit from these lower prices. But much does depend on how these policies are received domestically as the mid-term elections approach in November. And we simply can’t be sure.
There is one source of geopolitical risk on which we are more optimistic – Brexit. By the end of the year, we expect a deal to be agreed – one that largely preserves trade in goods and services.
The progress made at the prime minister’s cabinet gathering at Chequers moves the UK government closer to such a deal. The cabinet has recognised that given the importance of the EU in UK trade it needs to prioritise an ongoing partnership. And so it will have to accept the EU’s regulatory standards. While this may look like a concession on the UK’s ambition to restore sovereignty, it is worth remembering that regulatory alignment is an important bedrock for trade.
Without common standards one country could have the ability to obtain market share by using practices which do not fit with the values of another (child labour as one extreme example, or chlorinated chicken as a less extreme example).
If our expectations are proved to be correct, there could be considerable implications for UK markets. We would expect to see a broad-based increase in sterling, which would in turn lower UK inflation at a time when real wages are rising.
The outlook for the UK consumer could improve significantly into next year. Given that unemployment stands at a multi-decade low, it is likely to be increasingly clear that the economy does not need such accommodative monetary policy. We expect the Bank of England to ultimately raise rates by more over the coming year than is currently priced in UK rates markets. Investors thinking about reducing risk in their portfolios – perhaps in response to the risks of trade war – should be mindful of this when thinking about an increased position in long-term UK government bonds.
Karen Ward is chief market strategist for EMEA at JP Morgan Asset Management