The damage from the trade war is likely to be seen most clearly in Europe. Europe is highly dependent on global trade and capex – the two components of global growth that are faltering. The European Union (EU) is also waiting to hear whether it is next on President Trump’s list of trade injustices to correct. The EU currently charges a tariff of 10% on cars that enter from the US, which compares to a tariff of 2.5% on EU cars entering the US. It is plausible that the harder the US administration goes after China, the less it will risk adding the EU to the agenda. But we can’t be sure. Auto production accounts for as much as 5% of total GDP in Germany, so this is a sizeable dark cloud.
Unfortunately there appear to be few domestic policy levers that can be pulled to support European domestic activity in the face of falling external demand. The only countries willing to use fiscal stimulus are those that are already heavily indebted, such as Italy. The war of words between Brussels and Rome continues, and Italy may be placed under an excessive deficit procedure.
Matteo Salvini, leader of the League party, is undeterred. Emboldened by his victory in the European elections, he wants to step up fiscal expansion with a flat tax. Although these plans will continue to draw consternation in Brussels, it seems unlikely the European Commission will issue financial sanctions on the eurozone’s third-largest country. Italy is too large to be treated in the same manner as Greece.
In Germany there is seemingly little political appetite for government spending or tax cuts, even though the interest rate on German government debt is now negative to 15 years and the cost to the German government of servicing its debt has plummeted. Germany remains unwilling to solve the key problem facing the eurozone: deficient demand.
As in the US, the pressure to keep the show on the road is falling on the central bank. But unlike the Federal Reserve, the European Central Bank’s (ECB’s) fuel tank is running very low given that interest rates are already in negative territory. The ECB has committed to keep interest rates at this level at least through the first half of 2020, and provided further liquidity. This leaves investors contemplating whether the ECB might eventually be forced to cut rates into deeper negative territory. In turn, this is weighing on the financial stocks that account for roughly 20% of the European benchmark.
MSCI Europe ex-UK financials and non-financials
Index level, rebased to 100 in January 2004
Meanwhile, the further decline in sterling demonstrates the impact of ongoing Brexit uncertainty on investor sentiment towards UK assets. There is much excitement about Theresa May’s successor and the potential for this to shift the process forward (see our On the Minds of Investors article).1
Our view is that the new prime minister is likely to face the same challenges as the last. Passage of any deal remains difficult when the House of Commons remains divided over what it wants from Brexit, which in turn reflects a population ever polarised between leaving the EU with no-deal and a desire to remain (see below).
If you had to choose one outcome of Brexit, what would you prefer to see?
% of respondents
This polarisation is significantly shifting the landscape of UK politics. At some point, one might assume that the heads of the Conservative and Labour parties will realise they have an incentive to work together to deliver Brexit to stem the damage being done to their respective parties. How quickly this realisation dawns, and the degree of damage to the economy in the interim, is still very much in question. In the meantime, investors need to understand the impact that no-deal Brexit would have on markets, vs the impact of a change of government.
No-deal would potentially send sterling lower, but UK Gilts and international FTSE 100 stocks higher, as repatriated earnings benefited from the weaker exchange rate. Meanwhile, a general election risks a change of government to the Labour party, which potentially would focus on less market-friendly practices. A Labour party advocating much higher government spending and a renationalisation of utilities and transport might result in a fall in the price of Gilts and domestic-focused FTSE 100 companies, in particular.
Given these scenarios, a bias in the UK away from small- and mid-cap companies, which tend to be more domestically focused, seems prudent. This should also help build in some resilience to portfolios were a recession scenario to materialise, as UK small-cap stocks have underperformed large-cap in each of the last three US recessions.
1 On the Minds of Investors: How will the Brexit negotiations conclude? Karen Ward, J.P. Morgan Asset Management, June 2019.