MARKET UPDATE 18/10/2024

Market sentiment: Hesitant. The rally on global stock markets that began in the second week of August, and which has pushed the MSCI World index up a tenth, appears to be on pause as investors scrutinise companies’ third quarter earnings numbers. Profit warnings from industry bell-weather stocks, such as ASML (semi-conductors) and LVMH (luxury goods), have triggered a little profit taking. There is concern over weak Chinese household and industrial demand, following an underwhelming announcement of fiscal measurers last weekend from the finance ministry. And there is a mixed outlook for consumer spending recently reported by U.S retail banks.

A small rise in G7 government bond yields has also dulled appetite for risk assets. This reflects stronger than expected economic data from the U.S, with rising Treasury yields tending to lift yields elsewhere. Furthermore, in the U.K, the gilt market is a little concerned over the quantity of new debt that the Chancellor Rachel Reeves will be looking to issue when she announces her budget on 30th October. However, a sell-off similar to the Liz Truss mini-budget two years ago is highly unlikely.

Looking ahead, risk assets such as stocks and credit, are likely to benefit from a number of supportive themes. A U.S recession appears to have been avoided, with the world’s largest economy in something of a ‘sweet spot’ at the moment. It is enjoying moderate growth, low inflation and falling interest rates. American companies are reporting the fifth consecutive quarter-on-quarter earnings growth (analysts are pencilling in +4.3% on the S&P500). History suggests that pre-election volatility often gives way to a relief rally.

A package of fiscal stimulus measurers is widely anticipated in the second largest economy, China. European stock markets, which tend to be led by exporters and multinationals, will benefit from these themes as well as falling interest rates in their own countries.

Investors should remain diversified, across asset classes and regions. Financial history shows that this is the way to maximise risk adjusted returns.

U.K tax hikes and investment. Will some of the tax increases being suggested deter the private sector investment that that the government is hooping for?

The approaching U.K budget will define the new Labour government. Chancellor Reeves, it is said, wants to ‘clean the slate’ and put public finances on a sustainable footing. A new golden rule will be introduced, that day-to-day government spending must be paid for by tax revenue. To meet this rule she is reported to be looking at £40bn of tax hikes and spending cuts, so that day-to-day spending is sustainable without borrowing.

Borrowing will be for investment only. Likely candidates will be schools, roads, houses and hospitals, as the government pursues a growth strategy based around investment in the workforce. It is hoped this spending will stimulate private sector investment. More public and private sector investment should lead to stronger GDP growth, boosting both tax revenue, and higher real household incomes. Result = happiness.

Economists, and the gilt market appear to be much more at ease with this model for growth, than with Liz Truss’ plan of unfunded tax cuts, but some analysts to ascribe the recent rise in gilt yields to worries of oversupply (along with rising Treasury yields).

Most of the £40bn needed to cover day-to-day spending is likely to come from increased tax on pensions, capital gains tax, non-doms, carried interest (in private equity) and from fuel duty. Cuts in government spending represent a harder political challenge, given how run down many government services already are, and likely union resistance. Some cabinet members have already gone public with their opposition to any spending cuts.

And here’s the bind for Rachel Reeves: the taxes listed above that are likely to rise, are the ones that potential private sector investors most care about. Raising them may limit the size of the private sector response to an increase in public sector investment. It certainly wont increase it.

Perhaps foolishly, Labour promised no new ‘taxes on working people’ ahead of the July election, so preventing increases in income tax, National Insurance and VAT. Together these raise around 70% of total tax revenue. By excluding these, a larger number of taxes, that bring in relatively small sums, have to be increased by relatively large amounts. (The government has since backtracked on National Insurance, with higher contributions from employers -but not employees- now likely, but no other tinkering is expected of these three taxes).

Trump and the stagflation risk. Raising tariffs on imports may promote domestic manufacturing, but at the risk of a stagflation developing.

Kamala Harris has outlined some orthodox, and some unorthodox, ideas on economic policy in recent months. If she wins the presidency, her proposed policies will then have to pass through Congress. There they will be examined, debated, and likely amended if they are passed, or they will fail. Her bid to impose a cap on grocery store prices looks particularly vulnerable. In contrast, Donald Trump’s key economic policy of raising tariffs can be implemented without Congress, by executive order. We commented on in this note on 16th September.

Since then, we have had some surprisingly robust labour market data. September non-farm payrolls were up 254,000, compared to 159,000 in August, and inflation data has been a little stronger than economists were expecting. Both of which have contributed to the recent uptick in Treasury yields.

For some economists, this suggests that the Fed should stop cutting interest rates now (though that might be to ignore the lagging effect of interest rates, on an economy, which are said to be between 12 and 18 months). The surprising robustness of the economy is leading to speculation from some analysts of a stagflation problem, should Trump win and raise tariffs.

The theory goes that higher import prices will lead to opportunistic price rises from domestic suppliers also, raising CPI goods inflation numbers. Meanwhile, exports will weaken in response to trading partners putting up their tariffs on U.S exports. This will lead to a rise in prices and unemployment, ie stagflation.

Eventually, of course, something will break. Unemployment may cause prices to fall back, companies produce less and recession beckons. More optimistically, strong prices might lead will lead to domestic companies expanding their output, and absorbing those who lost jobs in exporting companies. Trump clearly hopes for the latter.

But a nasty patch of stagflation might have to be endured first. And what would the Fed’s response be? The last thing Trump wants to see is higher interest rates from the Fed.

Chinese stocks…waiting for the fiscal package. Economists and invests await the big announcement. The CSI 300 index of leading Chinese stocks rose by a third between 23rd Sept and 8th October, after the Peoples Bank of China (PBC) announced a number of supply-side measures designed to ease lending conditions, and the setting up of a fund to by domestic stocks. Chinese stock markets have since given up some of that gain, as investors wait for a companion package of fiscal measures to support demand in the economy.

Economists are specifically looking for support for demand in the economy, with a focus on household consumption, and help around debt restructuring with reference to the property sector. Estimates of the size of such a package vary enormously, from around $280 billion to $1.8 trillion. Last weekend Finance Minister Lan Foan announced policies designed to defuse the property debt risk, and hinted at a budget deficit increase to give fiscal support to demand in the economy, but provided no numbers and investors where somewhat disappointed.

The recent sell-off on the CSI 300 has had echoes on developed stock markets, with mining companies and European luxury goods hit by the (partial) reversal in sentiment. Global energy and industrial metal prices have also weakened.

The World Bank published a new China economic outlook on the 8th October, it is looking for 4.8% GDP growth this year (from 5.2% in 2023), and -in the absence of a large fiscal package- 4.3% next year. The Chinese government is looking for 5% GDP growth both this year and next.

Given that Chinese stocks remain cheap relative to their history, and to other major stock markets, the risk of staying in the market appears outweighed by the potential rally to come once Beijing comes up with a fiscal package. If it comes with an additional set of structural reforms that will reduce the high savings rate, and encourage spending, so much the better.