Market Bulletin (22/11/2016)
Hyperinflation began in thirteenth-century China when imperial eagerness to print paper money made the imperial currency close to worthless. It has since felled enough dynasties and governments to become an abiding concern of politicians, central banks and market participants alike. After several years of marginal inflation in leading economies around the world, markets last week signalled their belief that inflation is making a sustained comeback. Their primary focus is the US.
Last week, the spread between US Treasuries and German Bunds reached its widest level since 1989. In other words, investors now insist on a far higher yield for holding US government debt than for holding German government debt. The reason is Donald Trump, who has promised to spend up to $1 trillion on infrastructure and to cut taxes. As a result, markets are betting that US growth, inflation and interest rates will all rise together.
Janet Yellen appears to agree with those outcomes, if not necessarily for all the same reasons. Last week the chair of the Federal Reserve expressed her confidence in the trajectory of US growth and gave her strongest indication yet that a rate rise is likely in December. By Friday, markets were pricing in the likelihood of a December rate rise as higher than 90%.
The impact was felt internationally too. Global inflation expectations reached their highest level in more than a decade and there were signs of a significant rotation of funds from bonds to stocks last week, as investors banked on both positive company growth and rising interest rates.
Assumptions about Donald Trump’s future policies may be premature, not least because fiscally conservative Republicans in Congress will look askance at his borrowing plans. Yet there were other reasons for economic optimism last week, as US weekly jobless claims struck a four-decade low and US housing starts reached a nine-year high. The VIX, which measures volatility on the S&P 500, ended the week comfortably below 13.5 – the average is 20. The dollar rose in value, helping the Nikkei 225 up 3.4% as yen-based exporters receive a competitiveness boost.
The S&P 500 rose 0.77%, helped in great part by banks. The S&P Banks Select Industry Index has recovered from a 25% dip earlier in 2016 to end up 12% for the year to date – last week it rose some 4% on hopes that Donald Trump would follow through on promises to cut corporation tax and income tax; and to dismantle the post-crisis Dodd–Frank Act which, as well as introducing more onerous regulations, obliged banks to set aside large sums to cover potential losses. Coalition, a consultancy, said last week that combined third-quarter revenues at the largest 12 banks were up by more than a tenth, year on year.
Meanwhile, the UK enjoyed its own bout of positive data, including a stunning 1.9% monthly rise in sales volumes, its highest growth rate since 2002. Unemployment reached an 11-year low, and the UK jumped five spots in the World Bank’s league of most business-friendly tax regimes to reach tenth place. The FTSE 100 ended the week up 0.67%.
Yet much of the focus was turning to Theresa May’s government making its first significant announcement in the week ahead: the Autumn Statement. The government has remained, depending on your view, sensibly or eerily silent over its plans for Brexit since Theresa May succeeded David Cameron in the summer. Last week the former head of the Foreign and Commonwealth Office (FCO) warned that the government lacks a clear direction on Brexit and that the civil service would need to recruit a further 30,000 Brexit-focused staff – a leaked memo also accused the Cabinet of lacking an agreed Brexit plan. Moreover, Wolfgang Schäuble, the German finance minister, said in an interview last week that the UK could not escape its liabilities (potentially up until 2030), would not receive special treatment on immigration, should not maintain its euro clearing business, and could expect to see some financial services companies move to Frankfurt.
Reports last week indicated that Philip Hammond’s Autumn Statement this week will include a forecast that Brexit will cost the UK £100 billion within five years, marking the biggest dip in the public finances since 2011. The Office for National Statistics believes the debt-to-GDP ratio will rise from 83% to 90% this year. Philip Hammond tends to be as understated in his announcements as Donald Trump is flamboyant, and he may feel still more constrained by these projections. Stamp duty and tax receipts have slipped since the summer and the Institute for Fiscal Studies warned last week that the chancellor will need to deal with a £25 billion shortfall in the government budget.
Pensions could receive special attention, since pension tax breaks currently cost the Treasury £43 billion, although Hammond may be reluctant to further complicate what is already a convoluted regulatory area. He could potentially cut the lifetime allowance, which is currently set at £1 million – the annual allowance is another possible target. If he is looking for savings, then it is unlikely that additional rate and higher rate earners will receive improved tax incentives to make pension contributions – indeed, the reverse could even be true. For these reasons, high earners may wish to take advantage of the allowances currently on offer, and of their freedom to ‘carry forward’ their last three years of unused allowances.
The chancellor, who enjoyed a successful career running a construction company, may instead choose to focus his attention on business. The Institute of Directors last week called on him to “act decisively” by using fiscal policy (via targeted tax breaks) to offer help to UK-based companies. The Office of Tax Simplification, an independent Treasury consultancy, last week published its second round of proposals to reform the tax system by streamlining National Insurance and Income Tax calculations, potentially benefiting 7.6 million lower earners. There are also reports that ‘infrastructure bonds’ are being considered as a way of funding energy and transport schemes, which could provide significant opportunities for transportation and engineering firms, as well as UK housebuilders. At the weekend, Theresa May wrote of a “new industrial strategy” to boost innovation and technology. Yet Hammond may choose to remain vigilant and bide his time – inflation in October was 0.9% and is expected to rise.
Inflation is even beginning to rise in the eurozone, albeit more marginally, reaching 0.5% in October. But last week the European Central Bank indicated that it is not done with quantitative easing. The FTSEurofirst rose 0.44%. Meanwhile, the EU is looking at making it easier to block subsidised or ‘dumped’ imports by using emergency tariffs – like Donald Trump, it appears to be listening to protectionist voices.
That concern reflects how politics is changing the economic and trade outlook in the wake of the votes for Brexit and for Donald Trump. On 4 December, Italian voters will head to the polls in a referendum on proposed constitutional reforms that would empower the prime minister to make reforms, while weakening the Senate. Matteo Renzi has said he will resign as prime minister if he loses – and more than 30 consecutive polls since October have said he will. A loss would augur badly for 2017, when a series of national elections take place in France, the Netherlands and Germany.
“If we get a Brexit or Trump-like situation, if we get Marine Le Pen [elected in France] or a far-right movement gaining votes in Germany… then lots of things can happen that will destabilise the equilibrium that Europe currently enjoys,” said Neil Woodford of Woodford Investment Management. “If anything, I am more concerned about the political risk in Europe than what is likely to happen under a Trump presidency. I am watching very carefully what may happen [in Europe]. If investors start to doubt the sustainability of the euro then that will be quite a moment for markets.”
Woodford Investment Management is a fund manager for St. James’s Place.
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