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Better value in markets once the clouds lift

John Redwood, Charles Stanley’s Chief Global Economist, explains our current view on asset allocation.

John Redwood

in Features


When the Charles Stanley Investment Strategy Committee met this week we needed to ask if anything had happened in recent weeks to change our generally optimistic view for world economies and markets over the next twelve to eighteen months. The sharp sell-off in China and the euro area in October, with lesser falls in the US, Japan and the UK, were triggered by those who think the economic cycle is about to end. They point to monetary tightening, with rate rises in the US and UK, an ending to quantitative easing in the Eurozone, and emergency interest rates to ward off currency collapse in some emerging-market countries. Investors have understandably been fretting about the stand-off over the Italian budget, and the continuing trade war between the US and China.

The main way economies are taken into recession is through undue monetary tightening by a central bank, possibly allied to problems in a commercial banking system. This usually happens when central banks think they have been too lenient for too long, and have allowed inflation to get a hold again. There is little evidence that inflation is yet a major prospect in the advanced economies, with most of them reporting inflation around central bank targets. In the past, further economic growth might have pushed up wages and prices more rapidly, but today a global market with plenty of surplus labour and spare capacity to make goods seems to keep these pressures under control. The Committee decided to stick with its base case of around 3% growth for the world again next year, even allowing for some more tariffs on trade with China and a possible US attack on the German car industry. Growth is likely to slow a bit as the tax effects in the US wear off and as China slows as a result of current policy.

The negative case, ranked with a one-in-four chance of occurring, now has several different dramas that could unleash it. The current stand-off over the Italian budget could lead to the EU and the European Central Bank getting too tough with Italy to the point where there are tensions within the Italian banking system, bond yields rise rapidly, and liquidity proves insufficient for banks to honour all their obligations to Italian depositors and would be borrowers. We saw this playbook with Greece and with Cyprus in the past. If something similar happened to Italy there would be a big fall in markets, as Italy is many times the economic size of Greece and would damage markets well beyond Milan and Rome. For that reason our base case presumes both sides will find some accommodation or fudge to avoid such a development.

The escalation of the dispute between President Trump and President Xi of China is also unhelpful. The two are not just in disagreement about some tariffs and over how China handles the intellectual property of others. There is something of a trial of strength underway, from naval exchanges in the South China Sea to the construction of rival alliance patterns in Asia and the Middle East as each tries to extend his influence. Our base case assumes Mr Trump will wish to do a deal at some stage. His whole strategy is based on promoting faster growth and a stronger US economy so there are limits to how much damage he can do to others without also damaging corporate America.

The little-mentioned characteristic of President Trump’s book The Art of the Deal is his wish to protect against downside. The president is more strategic than his critics allow. He has stuck to his pre-election promises to cut taxes, deregulate banks and energy companies, and taken a series of actions designed to increase growth and jobs. This implies that President Trump will not overplay his hand on Chinese trade. We can see this same approach in his attitude to Iran. He wants to change their policies, but he does not want his sanctions to drive the world price of oil up too high. He has proved to be quite flexible on giving other countries some leeway to carry on buying Iranian crude.

November should provide some answers to the two big worries over Italy and China. Our base case thinks we will muddle through. Better news on these fronts would make us more bullish.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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