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Trade War Compromises and Populist Impasse
22nd January 2019
Gary Dugan
By Falco Group
Investment Committee
  • Markets hope that the US and China are on a path to compromise on the trade war
  • Chinese assets supported by low valuation and more help from the authorities
  • The US government closure is unprecedented and reducing growth
  • The UK Parliament struggles to find any kind of consensus
  • UK assets probably discount a good measure of a bad outcome
  • Market conditions may support the outperformance of active funds in 2019 after a poor 2018

Financial markets were in a more positive mood last week with hopes for a compromise on the US- China trade war offsetting the impasse in both the US (government shutdown) and the UK (Brexit). In the UK the markets managed to put a positive gloss on the UK parliamentary vote that saw Theresa May’s government lose the vote on its Brexit motion by a record margin.

The closure of the US government is starting to set records that do not bode well for first quarter US GDP growth. As the most extended closure of government ever, the White House estimates that it is taking around 0.08% off GDP growth per week. President Trump has offered some concessions on his positioning on the handling of immigrants. However, the Democrats continue to block his central policy of spending on a wall. There remains little sign of where the compromise will come from.

For the moment the financial markets are quite sanguine about the government close-down on the premise that whatever output is lost throughout the period of closure will be made up in its immediate aftermath. However, there are signs that the close-down may leave some scars on the economy that may never repair. While government employees will get their back pay, contractor’s income will be lost. Some companies will inevitably go bust in the absence of their usual work and cash flow from the government.

The political divisions in the US have more than their match in the United Kingdom. The vote in Parliament, and the unprecedented vote against the Brexit motion proposed by the government only highlighted again how difficult it would be to find a compromise that can be agreed in Parliament and with the EU. Economists can only guess at the damage to the UK economy from the ongoing lack of certainty about the future status of the country’s relationship with the EU.

The myriad of potential outcomes in Parliament has made it difficult for the financial markets to be certain about any one possible outcome. The difference between the UK leaving without a deal and recommitting to the EU are huge. At this stage, the equity market is at close to twenty-five-year low relative level to global markets. FX experts generally see sterling as cheap with a fair value somewhere above $1.40. A good measure of the bad news must be factored into the price of UK assets. The one thing that goes away when Parliament finally agrees some path is uncertainty. For sure an unstructured exit from the EU would clearly do some further damage to UK markets.

From Asia, there is a whiff of hope that the next few months could see some better news on the trade war front. There are growing hopes that the US and Chinese governments will find a compromise. Such an outcome will at least lift some of the gloom that has hung over the global economy. We will enjoy the good news when it comes, but we also continue to reflect on the longer- term trend that the US is clearly more than ever concerned about the economic power of China. The US will continue to get relatively smaller in the global economy. China and India will inevitably get bigger. The US is not always ready to give these growing economies their implied market share of industries such as technology.

A trade deal could help the Chinese equity market to recover from its sustained underperformance in 2018. The recent economic data has not been good. The Chinese economy grew at just 6.6% year-on- year in 2018 the lowest rate of growth since 1990. The equity market is down 25% from 2015 and 50% from its absolute peak.

The challenge for the Chinese authorities is that they are trying to balance ongoing reform with maintaining a robust growth rate. Growth although slower but it is largely in line with the level the authorities had targeted. More recently the government and central banks have been at work to support the economy. The PBOC gave the markets a jolt last week with the largest ever daily capital injection of funds at $140bn for the day and $230 bn for the week. The PBOC has already announced measures trying to encourage banks to lend less to state-owned companies and focus on small and medium-sized enterprises.

Last year was a miserable year for active management in the fund management industry. The FT carried the story this past week about the record outflows from actively managed US equity funds.$143bn of outflows were seen for US actively managed funds in December brings to a close a dreadful year for actively managed funds in almost every asset class. Morningstar data shows that the average manager underperformed their benchmark in virtually every major asset class other than Global high yield bonds. The average US large-cap equity manager underperformed by 100bpps, in European equities there was underperformance of between 200bps and 500bpps. In global bonds, the average manager achieved a return of 0.5%, but this was 130bps adrift of the benchmark.

The impact of quantitative easing has provided at least one excuse for the active managers. Central bank quantitative easing has helped to support even the weakest of companies through reducing the cost of debt for even the weakest of companies. Also, a large measure if market returns have come from the benefit of share buybacks rather than operating performance. Hence the usual dispersion of stock or bond performances has not been evident. Consequently, active managers have had a smaller opportunity to try to exploit with active management.

Active managers will be hoping that conditions will be much more comfortable in 2019. The fact that the Federal Reserve is slowly pulling back on quantitative easing and the European Central Bank (ECB) is no longer expanding its QE should take some of the props from companies that would otherwise have struggled in more normal circumstances.