The key market risk right now

Etienne Alexiou

Belay Capital

Let's first consider  the broader global economic environment, in particular, the  macro drivers of a “globally co-ordinated” gradual improvement in economies which are continuing to evolve. The primary driver of markets, at this point in time, is globally accommodative monetary policy, which underpins economic expansion and the rise in financial and real asset prices.

Coupled with the lack of any sustained response in markets to the negative surprises of Brexit, the Trump presidency, the subsequent disappointment in the lack of US government policy implementation and broadly benign global data, places us in the ‘Goldilocks’ zone of accommodative monetary policy, improving earnings and low volatility.

In this environment an absence of US government policy change might not be at all a bad thing. While at first glance, it doesn’t appear to be something that will pass through the house, let’s consider the proposed tax cuts in the US for a moment.

What could we expect from the US?

With US unemployment at 4.3%, US government debt at its ceiling at a time of large scale central bank bond purchases and the Federal Reserve Bank intending to further reduce its balance sheet and increase rates it is likely that “The biggest individual and business tax cut in American History” would have a low multiplier effect.

It would however add trillions in debt with a modest positive offset from the corporate repatriation tax. The amnesty on offshore held earnings in 2004 was at a 5.25 percent tax rate and two thirds of offshore held US earnings were repatriated at that time (which today would be $1.7 trillion of repatriation or a $70 billion tax collection).

It is worth noting that the cash repatriated in 2004 flowed predominantly to financing activities (mainly share buybacks) and not building more US manufacturing capacity or more jobs. Were the 2004 behaviour repeated this implies a very hefty 5 percent of US market capitalization. Naturally offshore earnings are much more concentrated in certain stocks which would be the likely candidates for large share buybacks. Thus, on the current tax outline we would see an increase in the share prices of the US multi-nationals who hold significant offshore US earnings (Apple et al).

Specifically, on the intended tax cut to corporates from 35% to 15% it is difficult to avoid the obvious conclusion that the sector in which earnings are very positive and debt levels low are getting the largest allocation of tax payers moneys. Alongside the repeal of inheritance tax and with high goverment debt levels this will be unpopular.

The current argument from republicans is that US companies have the highest tax rate of any of their major trading partners. Which is important, except almost no US corporate pays an effective tax rate of 35% (effective corporate tax rate in the US is circa 19%). Most would not have even benefitted by the originally mooted reduction to 25%, hence we are now discussing 15%. Which for many will represent an important but not significant change from current effective tax rates paid.

The additional government debt and the additional increase in the federal funds rate would however lead to higher public and private financing rates and potentially disrupt the ‘Goldilocks’ environment.

The further stated aim of the tax outline is to “Grow the economy and create millions of jobs”. At close to full employment, job creation pushes up wages and creates inflation by generating higher spending and investment which increases the price for goods, services and money. That doesn’t sound like something that would benefit markets longer term.

In all, the lack of execution on US government policy (despite the Trump media show) isn’t such a bad thing.

Biggest risks lie in Europe and the UK

So now looking forward to June, we should think about what could potentially shake the international markets. The greatest concentration of event risk is most certainly Europe/UK.

On the 8th June we have the UK general election and the ECB meeting. The ECB president Mario Draghi has outlined his thinking on ensuring monetary policy remain supportive for the time being, this stance is not likely to change. Whilst the ECB likely feel that more comfortable with growth, inflation has remained benign enough to allow current policy to remain in place with little change to forward guidance.

Theresa May’s gamble seems destined to have a lower pay off than polls originally suggested. Polls taken prior to the latest acts of violence in London showed the gap to Labour narrowing further. The attacks themselves have had the effect of making the Tory’s look disorganised. Given this early election is about achieving a strong mandate to negotiate a hardline Brexit the Tories are looking vulnerable. The outcome is most likely less rather than more certainty which will weigh on investor confidence in the UK.

Greece is due to rollover 5.2 billion Euros of debt in June and 11.7 billion Euros of debt in July. The Greek finance minister has successfully moved to quell fears that Greece intends to default. We will be watching the negotiations for the large debt rollovers in mid-July very closely. The economic recovery in Europe and particularly the almost embarrassingly good German export and manufacturing data will add to the Greek’s sense of outrage at austerity. Europe in all however is underwritten by an accommodative ECB.

Japan looks fair

Japan continues with its highly accommodative monetary policy stance and has seen some positive surprises to its economic data of late. Japan continues to represent a relatively good investment case with very accommodative monetary policy and solid economic data (Nikkei 225 topped 20,000 last week for the first time since 2015).

Australia: avoid property or equities!

In Australia May was a difficult month for the two asset classes Australians hold their vast majority of wealth in. The ASX finished down 3.4 percent and house prices were down over 1 percent in major cities. The RBA has made it clear that fiscal stimulus is a discussion worth having, particularly around infrastructure. Like most global central bankers Governor Lowe would be concerned that monetary policy has limited positive transmission into real activity at these levels of rates.  Australia is in a very different stage in the economic cycle to the rest of the world, having sidestepped recession we remain a relatively expensive country, which was all well and good when the costs of the inputs to investment were justified by the returns to capital.

Diversification away from Australian property and equities would seem very prudent in a balanced portfolio at this stage!

Etienne Alexiou
Chief Investment Officer
Belay Capital

Etienne is co-founder and Chief Investment Officer of Belay Capital.

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