When risk met uncertainty

Global financial markets have entered a period of significantly increased risk as uncertainty about three key processes intensifies. These are: the US-China trade war, Brexit and stalling growth with rising government debt, writes Victor Hill.

Economic climate change

Last Sunday (09 June) Madame Lagarde, the head of the IMF, warned that global growth was under threat from mounting tensions over trade and rising levels of government debt. She didn’t specifically mention the little local difficulty in North West Europe – but that is increasingly a ghost at every feast. “The road ahead remains precarious and subject to severe downside risks”, opined Madame Lagarde.

The highly cultivated French lady urged the US and China to drop tariffs altogether – thus illustrating that rationalists are not always realists. Meanwhile, Mr Trump’s assault on his southern neighbour Mexico was cancelled. Mr Trump had threatened to impose increasingly swinging tariffs on Mexican exports to the USA if Mexico did not act to restrict the flow of Guatemalans and others through its territory towards the USA. The Mexicans complied almost immediately. This is the first time that Mr Trump has used the threat of trade sanctions as an instrument of his immigration policy. It worked: job done.

The US equity markets surged last week – not just because of Mexican cooperation, but because Fed Chairman Jay Powell indicated that rates would have to come down soon. An unexpected slowdown in the US jobs market was the putative justification. The real reason is that the Fed – like everybody else – is concerned about the slowdown in global growth and the resulting contraction in US manufacturing. Cyclical indicators like house prices and car sales are softening in the US.

Citibank has predicted a recession for December this year based on the inversion of the US Treasury yield curve. Another red light flashing is that German 10-year Bunds are now yielding an all-time low of minus 0.23 percent in the continued flight to quality. The spread between the yield on the German Bunds and Italian government debt is heading back to the market-critical level of 375 basis points. Bank of America claims that investors have stopped believing that the ECB is capable of curing the Eurozone malaise of deflation. The rate at which the ECB lends to eurozone banks is already at minus 0.4 percent and it cannot realistically go lower.

The Germans, in the last act of Frau Merkel’s chancellorship, have vetoed both fiscal union (at least as favoured by the President Macron) and Keynesian demand management. Italy is being told to tighten its budget further. On Wednesday last week (05 June) Brussels triggered a penalty procedure which could lead to billions of euros of fines being imposed on Rome for failing to conform to eurozone spending rules.

Signor Salvini (who is the de facto Italian prime minister) argues that Italy has been crippled by years of austerity and that the country needs a fiscal shock to stimulate growth, including both tax cuts and spending hikes. But Brussels thinks that Italy, with its catastrophic debt-to-GDP ratio of about 132 percent (and rising) cannot afford any fiscal stimulus. Tension is building because rumours suggest that the collapse of the odd couple government (a coalition between the right-wing Lega and the flaky, “populist” 5 Stelle) is imminent. There could be early elections as soon as September. Signor Salvini’s anti-immigration party is ahead in the opinion polls and might be able to form a coalition government after the next election without 5 Stelle. The yield on Italy’s 5-year bond is currently higher than that of Greece.

Italy’s economy has hardly grown since the advent of the euro in 2002 while Germany’s has swelled by 20 percent. And yet the country has run a primary surplus (that is to say the budget balance with debt interest payments taken out) for the last 25 years. So it is difficult to argue that the Italians have been profligate. In fact, Italians, in my experience, are on a personal level more provident even than Germans. Rather, a deflationary single currency has condemned them to debt levels which have become unsustainable.

There will be a reckoning in due course: it is just a question of when.

Trump’s trade war: increased downside risks

The US-China trade war rumbles on. Last year the US bought $539 billion of Chinese goods but sold just $120 billion of goods to China. So the US ran a trade deficit with China of $419 billion, reflecting huge American demand for Chinese goods – but also the fact that American goods and services have only restricted access to the Chinese market. Last week, Beijing said that the $419 billion figure was “false” and that the real trade deficit was only $153 billion.

In May, Mr Trump raised tariffs on Chinese goods entering the USA from 10 percent to 25 percent. The Chinese responded with tariffs also of 25 percent on an estimated $60 billion of American goods going to China. These tit-for-tat tariffs are impeding investment flows globally and thus, prospectively, global growth. The World Bank cut its global growth forecast for this year last week from 2.9 percent to 2.6 percent. Global trade, while still expanding, is growing more slowly. It grew by 4.8 percent in 2017 and 3.3 percent in 2018 – but will grow by just 2.6 percent this year.


During the first week of June the rhetoric became more aggressive on both sides. Mr Fu, an ex-CEO of the Chinese state-owned oil giant Sinopec (NYSE:SNP), told a forum in Shanghai that China should prepare for a US oil blockade. This got China worrying – the country has only 40 days of oil stocks in reserve. China’s state-controlled media then offered a counter-strategy: to cut off the export of rare earth minerals to the US (and its suppliers). China mines about 80 percent of global production of these strategically vital elements – and controls much of the global processing chain. This news spooked the markets for a few days in the first week of June.

Meanwhile, China is trying to get its own back for the Trump administration’s scorn for Huawei (SHE:002502). It is drawing up a black list of “unreliable entities”. And Congress is considering slapping sanctions on China over its treatment of Uighur Muslims…

Mr Trump will decide whether to slap additional tariffs on Chinese goods entering the US after meeting President Xi at the G-20 summit in Osaka later this month (28-29 June). China’s exports to the US amount to 23 percent of its total exports while US exports to China are just 7 percent of total American exports. That means that, in principle, Mr Trump holds the upper hand.

A resolution of the trade dispute could unlock delayed investment. China doesn’t want a protracted trade dispute to stymie global growth – or so optimistic economists tell us. There could be positive developments in Osaka later this month which would buoy the markets – but don’t hold your breath. That said, the emergent Cold War between the US and China that I described recently has only just begun.

Brexit: it can only get worse…

The most extraordinary thing about the current prime ministerial contest is the welter of un-costed tax and spending proposals spewed forth by the leading Tory candidates (reduced to seven as of yesterday). There is the danger that the good work done by Mr Hammond to repair state finances could soon be undone. I’ll take a close look at the leading contenders’ proposed tax reforms next week – when we should know who the final two will be.

Overall, the uncertainty around the final outcome of Brexit has hit manufacturing hard – especially in the automotive sector, with car production in April at about half the level of the previous year. The UK services sector, however, which is 80 percent of the economy, is humming. The HIS Markit Purchasing Managers’ index out on 05 June at a score of 51 suggested that the services sector is upbeat and is recruiting aggressively in a tight jobs market. As a result there is further upward pressure on wages. The labour market continues to thrive with another record of 32.75 million people in work and a jobless rate of just 3.8 percent. As PwC observed this week, the UK economy is a job-creating machine.

Upward pressure on wages could feed through to higher interest rates in the UK. Mr Carney has repeatedly said the Bank of England might need to raise rates by more than the market anticipates. Growth for Q2 2019 is expected to come in at around 0.2 percent – well below the 05 percent recorded for Q1.

One example of the effect of Brexit uncertainty is the UK housebuilding sector. Last month Crest Nicholson (LON:CRST) warned that the demand outlook had been clouded by “ongoing political turbulence” – though the company reported a 4 percent rise in revenues.

Furthermore, footfall through Britain’s shops was down by 3.5 percent overall year-on-year in May, and down 4.8 percent in our high streets, according to the British Retail Consortium (BRC). That was the biggest fall for six years. This partly reflects the long-term structural decline of bricks-and-mortar retail with Arcadia(private) achieving a restructuring (CVA) and the franchise Jamie’s Italiancollapsing with the loss of 1,000 jobs. Meanwhile, online retailers like Boohoo (LON:BOO) are thriving.

The outlook for sterling is much in question. Kamal Sharma, chief currency strategist at Bank of America thinks that the pound could plunge in value to $1.10 in the event of a messy no-deal Brexit. The UK current account deficit (CAD) stands at 4 percent of GDP, making the pound vulnerable to a global downturn. Moreover, given the pound’s reserve currency status global reserve managers hold about £500 billion of sterling reserve assets which, in a major disruption, they might decide to unload all at once.

On the other hand, sterling is already undervalued by most conventional metrics (as is the UK stock market). A secretive body called the Exchange Equalisation Account (EEA) – an agency of the Treasury, but physically located inside the Bank of England – is reported to have built up a war chest to protect sterling from a global assault by using repo contracts in the currency markets in the event of a major shock.

In the second half of May the pound recorded an unprecedented 11 consecutive days of losses against the euro – the longest losing streak since the single currency was created in 1999. In foreign exchange circles, a win by Mr Johnson in the prime ministerial contest would signal an increased risk of “accidental no-deal” – and sterling could be priced accordingly. Personally, I cannot think of any counterpart – with the possible exception of Mr Trump – more likely to get up Brussel’s collective nose than Mr Johnson. He is loathed and distrusted by the European elite in equal measure (which is precisely why the Tory grass roots adore him). Tory MPs who believe that the European machine (or the Labour Party) will change course when confronted by Mr Johnson are deluded.

On Tuesday (11 June) Ronan Harris, Google’s CEO for Britain and Ireland, after meeting Mrs May, told journalists at London Tech Week that he was having to work harder to explain what is going on in the UK to colleagues in Silicon Valley. “It’s creating uncertainty”, he said. Recently Google announced plans to raise its staff numbers in Paris by 50 percent to 1,000.

An American pivot?

Mainstream media thinks that Mr Trump is unsophisticated. Actually, the strategic objectives of the Trump administration are acute. The US wants the UK to go for a “phenomenal trade deal” at the very moment that it leaves the EU orbit.

While the EU is offering the UK with the Withdrawal Agreement and the Political Declaration a kind of legal formaldehyde by means of which the UK will be pickled in the EU Acquis for years, if not decades (with “the customs union as the basis of future relationship” as Sabine Weyand declared), the US is offering a transparent trade deal. That would be likely to contain things which were not universally welcomed in the UK – but it is not as if we would be accepting the writ of the US Supreme Court over domestic policy.


Personally, I have no problem with chlorinated chicken: we ingest more chlorine in the UK in the water we drink than if we were to eat a Yankee chicken every day…And it will not be compulsory to buy US poultry…Moreover, I welcome US healthcare companies (which are amongst the best in the world) being able to offer services to our NHS which is much in need of best practice. (Calm down, Mr Hancock – you will shortly have much time in which to reflect on these matters…)

That said, a no-deal Brexit would entail going cap-in-hand to our American friends – just as we did in 1940. We should not expect them to be accommodating. The Remainers would cry foul – and the country would be more deeply divided than ever.

The return of QE

Last week James Bullard, CEO of the Federal Reserve Bank of St Louis, and then Jay Powell, Chairman of the Fed, mooted the possibility of imminent rate cuts. The trend to tighten monetary policy which began in 2015 is now over. Since then the Fed funds rate has risen from 0.25 percent to 2.5 percent. Moreover, Mr Powell indicated that quantitative easing (QE) could stage a comeback. He said that QE should no longer be considered “unconventional”.

It now seems that Mr Trump’s criticism of the Fed earlier in the year for its hawkish stance on monetary tightening was justified. The futures markets now suggest that there is an 85 percent probability of a rate cut by September.

Increasingly, the main shape of QE is for governments to finance spending by issuing bonds which are then purchased by their own central banks using invented money. About 50 percent of government debt in Japan is owned by the central bank and approximately 30 of eurozone sovereign debt is owned by the ECB. Until now, central bankers have argued that QE is justified to meet their inflation targets – but it now seems that it is becoming a means of financing state expenditure. If that becomes normalised then there is a significant danger that inflation could return with a vengeance.

In Japan’s case, government debt amounts to about 250 percent of GDP. But at least Japan has control over its own currency – which Italy does not. The US is now running an annual budget deficit of $1 trillion and the economy, though still growing strongly, is slowing. As a result the US debt-to-GDP ratio is trending upwards inexorably.

Risk versus uncertainty: weather versus climate

At moments like this it is time for fund managers to reconsider their overall exposure to equities. John Higgins of Capital Economics expects the S&P 500 to decline by at least 17 percent before the end of the year. That would be bad news for Mr Trump’s prospects for re-election.

In Europe, the risk of recession is rising. Tension is increasing in the Gulf, putting upward pressure on the oil price. Regarding the UK, I feel profoundly uneasy about the prospect of Mr Johnson becoming prime minister – and many old hands in the City feel the same. The risk of a monumental cock-up of one kind or another would be off the clock.


As for the US-China trade war, I think it would be naïve to believe, like economist Liam Halligan[i], that it will all end sweetly with a handshake and a toast. If China convinces itself it is becoming the next Iran, it could lash out. The Japanese Empire attacked Pearl Harbour in December 1941 just weeks after the US imposed an oil embargo[ii].

Risk is the weather through which financial markets sail, knowing roughly the range of outcomes that are likely to happen most of the time. Uncertainty is when “normal” weather becomes unpredictable because the economic climate has changed. You can protect yourself from poor weather with appropriate clothing; but you can only combat a deteriorating climate – as human beings did over aeons of pre-history[iii] – by moving somewhere else.

[i]Writing in the Sunday Telegraph, 09 June 2019.

[ii]Years and Years, by Russell T Davies, envisages that Trump will strike first.

[iii]That was the fundamental theme of Fernand Braudel’s masterpiece Civilization and Capitalism (1979).