The first quarter of 2019 was a wild ride for capital markets — equities and government bonds rallied as U.S. Treasury yields and German bund yields sunk. This was a clear dichotomy, indicating optimism in the stock market but pessimism about the global economy. I believe this reflected more accommodative monetary policy from the Federal Reserve and other central banks, suggesting a more supportive environment for risk assets such as equities, while weakness in some economic data suggested a slowdown in global growth, pushing yields down. In this week’s blog, I discuss six current issues that could impact capital markets in April and beyond.
- Growing ‘Brexanity’ in the U.K.
On March 29, U.K. Prime Minister Theresa May lost a third vote on her proposal to exit the European Union even though, in an attempt to sweeten the deal, she had promised Conservative lawmakers that she would step down as prime minister if the deal was approved.
Earlier in the week, Parliament had rejected all eight options in the indicative voting process. May said of these developments: “The implications of the House’s decision are grave … I fear we are reaching the limits of this process in this House. This House has rejected no deal. It has rejected no Brexit. On Wednesday it rejected all the variations of the deal on the table. And today it has rejected approving the Withdrawal Agreement alone and continuing a process on the future.”1 May said she will press on with talks to secure support, with her political spokesman saying that the smaller margin of defeat from the prior two votes indicated that progress was being made as a number of senior Conservatives had voted with the government.
All in all, there is an enormous amount of uncertainty about Britain’s future. Dutch Prime Minister Mark Rutte said on Friday that there is a distinct possibility that Britain will leave the European Union without a deal: “The risk of a no-deal Brexit is very real. One of the two routes to an orderly Brexit seems now to be closed. This leaves only the other route, which is for the British to make clear what they want before April 12.”2 A further extension of the Brexit process beyond that date can only be granted if Britain knows what it wants, which seems to be a tall order right now.
The Brexit date has now moved from March 29 to April 12, with the possibility that it could be pushed out further. On April 1, there will be another round of indicative votes, with possibly more on April 3. Based on the first round of votes, opinion may coalesce around the idea to remain in the Customs Union only, and the idea to hold a confirmatory vote through a second public referendum. There is also a suggestion from the government that May’s Withdrawal Agreement could come back this week for a fourth vote. We could see the Withdrawal Agreement eventually coupled with something like the Customs Union idea. A general election for a new prime minister may also be an option.
The European Union (European Commission) will hold an emergency summit on April 10, at which point Britain has to tell it what it wants to do. If a vote is held between now and April 10 that finally ratifies the proposal on the table, Britain would have until May 22 to formalize the process through legislation (May 22 is a key date because the European Parliament elections are May 23-26). If it is decided that new elections will be held, this would require a long extension (if the U.K. were to ask for a long extension, then it would have to participate in the European Parliament vote). This is also true if Britain decides to hold a new referendum. Or, Britain could just go ahead and crash out on April 12 without an agreement — but that would be fraught with peril, as experts are suggesting this could lead to shortages of food and medicine, and other major issues.
U.K. equities and government bonds performed well in the first quarter, but that may not continue given that chaos has been dialed up with the events that unfolded in the last several weeks — and the potential for more uncertainty to come.
- U.S. Employment Situation Report for March
This report will be released by the Bureau of Labor Statistics on April 5, and the most important metric to look for, in my view, is average hourly earnings. We’ve seen a significant increase in recent months, and we want to see if that trend continues or possibly accelerates from here. Low inflation has given the Federal Reserve (Fed) the luxury to be patient. However, if inflationary pressures are starting to build, the Fed might not have that luxury much longer.
There is also heightened sensitivity around whether or not we are in an economic slowdown given lower Treasury yields and the Fed’s abrupt change in stance, so nonfarm payrolls will be important as a coincident indicator of U.S. economic health.
If wage growth is contained and payrolls aren’t anemic (recall that February’s jobs report indicated very anemic payrolls), then I believe U.S. stocks would continue to perform well, while investor worries would likely de-escalate, sending Treasury yields higher.
- Chinese economic data
China’s Manufacturing Purchasing Managers’ Index for March clocked in at 50.5, which was much stronger than expected — and actually was the biggest month over month increase since 2012.3 This was the strongest reading in the past four months, and it suggests that the significant stimulus from the Chinese government is finally impacting the economy.
This is consistent with the positive speech made by Premier Li Keqiang at the Boao Forum last week, where he indicated that government stimulus is having a positive impact on economic growth. I believe that the Chinese economy has stabilized meaningfully in the first quarter due to the government’s efforts, and I expect further recovery in the second quarter. I continue to expect large capital inflows into China and for the renminbi to further stabilize and strengthen. However, I will look to upcoming data to confirm those views, including the Caixin index to be released this week.
If we see continued stabilization and even improvement in Chinese economic data, I expect Chinese equities to post positive returns and major government bonds that are perceived to be “safe harbors” to see yields rise as investor worries decrease.
- European economic data
Given recent weakness in European data, we will want to follow eurozone unemployment and inflation releases closely. Much of the weakness has been in sentiment indicators, so we will want to see if this is impacting the actual economy.
European equities performed well in the first quarter, but I am not convinced that will continue if data remains relatively weak. In addition, such weakness would likely place downward pressure on U.S. Treasury yields and German bund yields.
- U.S.-China trade talks
Talks continued in Beijing last week. Some reports suggested that China was ready to sharply expand market access for foreign banks and for securities and insurance companies, especially in its financial services sector. It was also reported (by The Wall Street Journal) that China is offering foreign technology companies better access to the country’s cloud-computing market. U.S. National Economic Council Director Larry Kudlow suggested that if a trade deal is reached, the U.S. may keep some tariffs in place to ensure Beijing’s compliance. “We’re not going to give up our leverage,”4 Kudlow explained. Kudlow also said he expected negotiations to take some time — at least a few more weeks, if not months. “This is not time-dependent. This is policy- and enforcement-dependent.”4 The two sides are reportedly working on written agreements in six areas: forced technology transfer and cyber theft, intellectual property rights, services, currency, agriculture and non-tariff barriers to trade.
Despite what seems like significant progress, I am always cautious when I read news reports, as I don’t know who is providing the information and what their motive is. It seems that China’s economy is improving, which is a critical reason why I believe China is unlikely to make any major concessions to the U.S. — despite all the positive fervor around trade negotiations. Last week Li sounded a bit more ominous, although I believe his comments were overlooked: “We need to prevent a trust deficit from occurring — otherwise the damage it could do to U.S.-China relations is incalculable.”5
Talks will resume this coming week, so we should be prepared for news flow from those negotiations to potentially impact markets.
- Political pressure on the Fed
Following Stephen Moore’s nomination for the Fed the previous week, Kudlow called for the Fed to cut rates 50 basis points “immediately.”6 In my view, while this would be a strong positive for stocks in the shorter term, it would be dangerous for two reasons: it further politicizes the Fed, and it takes away some of the little dry powder the Fed has at its disposal to handle the next crisis. I wouldn’t be surprised to see continued pressure going forward; we will want to follow the situation closely.