Quarterly Market Commentary - June 2018
Despite the bout of increased volatility at the beginning of the year, stockmarkets are currently experiencing a period of relative calm and most developed stockmarkets remain near, or at, all-time highs. As a result, and without wanting to appear bearish on the future, we review and consider some of the main talking points that are being touted as possible catalysts for the volatility to resurface.
Our discussion points centre around the US Trade War and Italian politics.
When Donald Trump was inaugurated as the 45th President of the United States in January last year, it was on the back of a hard-fought political campaign that wanted to ‘make America great again’. His rhetoric was very much centred around protecting the interests of the US and the US people. Therefore, when Donald Trump announced plans in April this year to impose 25% trade tariffs on $50b of Chinese goods, he was certainly keeping to his campaign promises. The result, inevitably, was an immediate response from the Chinese authorities with tariffs of 25% on $50b of US goods.
The US is now considering tariffs on an additional $100b of Chinese goods. For China, there is limited ammunition for them in this trade war, given that they only imported $130b of US goods in 2017. A more likely response is for the Chinese authorities to consider selling US bonds or devaluing the Renminbi, both of which could increase the costs of borrowing for the US and strengthen the US dollar, economic fundamentals that Donald Trump would wish to avoid.
For the US, enacting tariffs or getting concessions could be Donald Trump’s way of boosting approval ratings rather than wanting an actual long-term trade war. This was clearly evident at the end of May when the Trump administration announced plans to raise tariffs on imported steel and aluminium by 25% and 10% respectively on three of the US biggest trading allies including Canada, Mexico and the EU. Donald Trump tweeted on 1 June that ‘Canada had treated American farmers very poorly’ and that ‘Canada’s trade policies are highly restrictive’. The immediate response from these nations – similar trade tariffs on US goods! There’s nothing like building the bridges with your economic and political allies only then to build a dam and raise the level of the river!
However, in this kind of fight, history seems to indicate there are very few winners. No one knows exactly what will unfold, but if history is any indicator, we can make a pretty good guess. There have been a number of trade battles in the last 80 years. Ronald Reagan imposed significant tariffs on Japan in the 1980s. More recently, former President George W. Bush imposed steel tariffs on Europe in 2002. He was met with threats of retaliation from European trading partners and soon after, he ended the tariffs.
However, if we look back to 1930s, the US was turning inward with protectionist policies. The government was restricting trade with other countries and in an effort to save US factories, a couple of congressmen came up with a plan. It was formally called the Tariff Act of 1930 but it's more commonly known as the Smoot-Hawley Tariff Act. The plan faced a lot of opposition but it ultimately became law. The act raised tariffs on US imports to nearly record levels but instead of reviving the economy, it actually exacerbated the Great Depression. Nations across the world were striking each other with tit-for-tat tariffs. European countries put a tax on US goods, which slowed trade between the US and Europe and the US struggled to emerge out of its economic slump. Nationalist rhetoric was heating up, with countries blaming others for their struggles, all of which eventually escalated, turning a trade war into a real war when World War II began. It was for this reason that the World Trade Organization was formed to regulate international trade in the hopes that nothing like the global trade war of the 1930s would ever happen again.
Despite concerns issued by Christine Lagarde of the IMF, the actual impact of a US-China trade war could be reasonably small. Some commentators have argued that the US would only witness a decline of Gross Domestic Product (GDP) growth of 0.3%. Indeed, Trump and his administration have insisted that the US economy will emerge stronger in the long run because the tariffs convince China to ‘cease harmful and unfair trade practices’. However, none of this takes into account perhaps the unintended consequences of this dispute including a 28% fall in direct foreign investment between the US and China. However this plays out, it is likely that no one will benefit!
Italy has been one of the best performing stockmarkets in Europe this year. This all changed two weeks ago when the political issues surfaced. To recap, Italy was close to forming a coalition government. Many viewed it as an odd-couple coalition with the ‘anti-establishment’ Five Star Movement and the ‘anti-immigration’ League on the verge of forming a government. They had even decided on a prime minister, a little-known academic called Giuseppe Conte. However, the Italian President, Sergio Mattarella, rejected the coalition’s choice of Finance Minister, Paola Savona, as he is a big Eurosceptic. Mattarella argued that his job was ‘to protect the nation’s place in the Eurozone’. Mattarella also appointed a former IMF Director, Carlo Cottarelli, as a stop-gap Prime Minister with the intention of holding further elections later this year.
Why did all of this matter? Well for two reasons. Italy is perhaps not well known for playing by the rules and they certainly do not like the prospect of possibly being dictated to and threatened by outside influences. The step taken by President Mattarella to stop a new coalition government being formed was the first time these Presidential powers have been used and largely viewed by the coalition contenders as a way of retaining and perhaps empowering EU control over Italy. This came at a time when the proposed new coalition is seen as a ‘populist’ movement, whose main campaign trail has been centred around reducing immigration, cutting austerity, increasing spending and possibly considering leaving the EU. The term ‘Italexit’ was formed.
Aside from the politics, however, is the economic and monetary repercussions of this. The coalition government was taking control of a country whose national debt is worth 132% of GDP. That is the worst in the Eurozone, bar Greece. The fear was that Italy would try to abandon any semblance of trying to pay down the national debt and, indeed, unconfirmed reports abounded last week that Italy was seeking to persuade the ECB to write off €250b. The populist coalition wants to cut taxes and spend more money, a result of which, could see Italy’s deficit rise from just 1.3% to well over the 3% ceiling that the EU wants its member countries to stick to. It perhaps did not help that the French Finance Minister tweeted that the Italians needed to stick to the rules. Matteo Salvini, head of the League, responded ‘This is another unacceptable pitch invasion. I didn’t ask for votes to continue on a path of poverty, precariousness and immigration. Italians first!’.
The result of the above is that the Italian stockmarket is down by approximately 10% over the last month and Italian 10-year bond yields rose from below 2% to around 2.9%. This is at a time when the ECB is likely to consider reducing or stopping its Quantitative Easing (QE) programme in September, where it has largely been buying Italian bonds. This could potentially increase the yield on future Italian debt. As with anything in Italian politics, however, anything can happen. In the last few days the coalition agreed to remove Savona as Finance Minister instead appointing him as European Minister!! Giuseppe Conte has returned as Prime Minister. Italian bond yields have fallen to around 2.6% but the political cloud and possible threat to the EU looms larger than the Greek crisis.
It is impossible to predict the future - especially whether stocks and shares will fall or rise. Therefore, it is important that medium to long term investors maintain a diversified portfolio to benefit from stockmarket rises when they happen and to dilute volatility when there is a fall. We strongly believe that a sensible investment strategy involves riding out stockmarket volatility.