In the January 2016 edition of Master Investor Magazine I penned an article entitled 2016: The year of living dangerously. That was the year of the Brexit referendum and the triumph of Mr Trump. Populism appeared to be rampant and the Eurozone was under severe strain.
But Europe did not fall to the populists. It was the Anglo-Saxons who set out on a post-globalist agenda of economic nationalism. That makes for divergence between the English-speaking world and the Europeans which threatens to undermine the post-1945 states system. And yet, in many ways, this understanding of reality is completely misleading. In fact, the “post-globalist” Anglo-Saxon economies are likely to remain far more open than the increasingly federalist EU, which, in my view, is likely to turn in on itself and adopt de facto protectionism.
This all takes place at a time when China and Russia are challenging America. Recently I speculated that this challenge will take the form of state monopoly digital currencies which will be used to trade, amongst other things, oil. Though it will take time for this trend to play out.
So how come I am so optimistic about the outlook for the US and the UK markets in 2018? In fact, I foresee that the Dow will continue to climb towards the 30,000 level during 2018 and may even surpass it. The FTSE-100 will move in its wake and, buoyed by a reduction in Brexit angst, will surge towards the 8,000 level. There is much to be optimistic about this year in the English-speaking world – as I shall try to explain.
Can the US markets keep climbing?
On Wednesday, 20 December a slew of American corporations announced one-off bonuses for their employees. AT&T (NYSE:T), the telecommunications giant, promised to pay each of its 200,000 staff a $1,000 bonus. Comcast (NASDAQ:CMCSA) the country’s largest cable TV operator, said that it would give its 100,000 staff the same. Wells Fargo (NYSE:WFC), one of America’s largest banks, promised to raise its minimum wage to $15 per hour, as did Fifth Third Bancorp (NASDAQ:FITB). A number of companies announced new charitable programmes amounting to billions of dollars. What is behind all this corporate largesse? American business, after Mr Trump’s tax cuts, is feeling extremely bullish about 2018.
True, Goldman Sachs recently went bearish on its US market outlook. In a recent note they pointed out that for an investor with a 60 percent equity and 40 percent bond portfolio this has been the longest bull market since the 1920s. The bank envisages either “slow pain” (a gradual adjustment) or “fast pain” (a sudden market correction) as values adjust to historic norms.
The conventional wisdom is that the Cyclically Adjusted Price-Earnings Ratio (CAPE) has hit a record high – which suggests that the US markets have peaked. Certainly, Jim Mellon thinks so. But let me give you two reasons why that may not necessarily be the case.
American business, after Mr Trump’s tax cuts, is feeling extremely bullish about 2018.
Firstly, the CAPE figures use averaged-out earnings numbers over normally a ten-year time horizon. That does not capture the sudden upsurge in corporate profits that has occurred relatively recently and which are likely to accelerate further in 2018. Obviously, one has to take a view as to whether earnings growth will revert to the mean over the medium-term: but 2018 promises to be a bumper year.
Secondly, one should remember that the surge in US stocks over the last year or more has been patchy. To be sure, the tech giants – especially Amazon.com (NASDAQ:AMZN), Facebook (NASDAQ:FB), Apple Inc. (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Netflix (NASDAQ:NFLX), Alphabet/Google (NASDAQ:GOOG) – have surged into the stratosphere. But, as I reported in the November edition of the Master Investor magazine, some sectors of the US market have declined markedly. I cited bricks-and-mortar retailers (such as the department store chain Macey’s (NYSE:M) and Nordstrom (NYSE:JWN)) which were down by 30 percent or so and which I speculated might be undervalued. If such Cinderella sectors recover in the face of strong consumer demand, the US market may have much further to go.
But ultimately, one has to assess the economic fundamentals – and these are sanguine.
The state of the American economy
The US economy grew at its fastest pace for two years in Q3 2017, largely driven by robust business spending. GDP in the world’s largest economy grew at an annualised rate of 3.2 percent, according to the Commerce Department. The question is whether this momentum can be sustained. Those who support Mr Trump’s package of tax cuts think that it can.
A key indicator, business equipment investment, was up by an impressive 10.8 percent – the fastest in three years. Consumer spending, which accounts for about two thirds of the US economy, was up 2.2 percent. This renewed emphasis on investment will be music to Mr Trump’s ears.
Other data released on 21 December showed that new claims for unemployment amounted to 245,000 in the week before Christmas. This was the 146th consecutive week that new claims were below the psychologically significant 300,000 threshold. With strong growth and a tight labour market the US economy is in fine fettle.
Mr Trump’s tax give-away
During the week before Christmas President Trump signed into law the tax reform bill which had spent nearly two months going through Congress. Despite numerous amendments – the final rate of corporate tax was set at 21 percent rather than the proposed 20 percent – Mr Trump got more-or-less everything he wanted.
The initial reaction from the markets was entirely favourable – despite siren voices warning that the measures will increase America’s fiscal deficit by another trillion dollars or more over the next ten years. This was both a tactical victory and a moral one in so far as it is the first time that the President has got a major reform package through Congress. Whatever you may think of Mr Trump – he has delivered on one of his principal electoral promises.
Do the tax reforms justify the enthusiastic market sentiment? The fact is that we won’t really know the answer to that for about two years. If the corporate cash cows (like Apple Inc. (NASDAQ:AAPL)) repatriate a significant portion of their offshore cash balances to the USA and if growth peps up, the tax measures will look like a great success. US corporations are reckoned to hold about $2.6 trillion in offshore tax havens, of which Apple accounts for $252 billion. On the other hand, if the a priori fall in the tax-take is not counterbalanced by more economic activity, then the tax reforms will be judged a failure.
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It is estimated that the cut in corporate taxes alone will provide an additional $200 billion of stimulus to the economy in 2018 alone. Nearly every company which operates in America will feel the effect of lower taxes and profits and the extra spending power of American consumers. This could add up to an additional 1.3 percent of economic growth in 2018 according to some estimates.
Critics of Mr Trump’s tax bill claim that it was railroaded through Congress without adequate scrutiny and that it will have to be extensively amended and refined. Tax accountants will be poring over the small print of this legislation throughout 2018 – and perhaps much beyond. Questions have even been raised as to whether the IRS, the US government tax agency, will have the wherewithal to apply the legislation correctly. In particular, “related party” expenses will be governed by a chapter in the legislation called BEAT (Base Erosion Anti-Abuse Tax) which could prove arduous to apply.
Another new rule states that interest expense deductions will amount to no more than 30 percent of EBITDA. That will negatively impact foreign corporations which finance their US operations with inter-company loans. It is thought that this could affect a number of foreign financial services companies.
British companies poised to do well from lower US corporate taxes
Intercontinental Hotels (LON:IHG) told shareholders on 21 December that Mr Trump’s cut in corporate taxes from 35 to 21 percent would slash its tax bill by “mid to high single digit percentage points in 2018”. Intercontinental, which owns the Holiday Inn brand amongst others, generates 64 percent of its earnings in the USA. Morgan Stanley instantly upgraded its earnings estimates for the company for 2018 by 10 percent.
Ashtead Group plc (LON:AHT), the industrial equipment company, is a British multinational which derives 85 percent of its £2.3 billion sales from the USA – more than any other FTSE-100 company. Similarly, Shire PLC (LON:SHP) has the second largest proportion of US sales out of the FTSE-100 with 67 percent generated in America. Smaller UK listed companies with huge sales in America include BBA Aviation (LON:BBA) (87 percent) and Indivior (LON:INDV) (81 percent).
Other British companies to note which are big in America include Ferguson (LON:FERG), Pearson (LON:PSON), National Grid (LON:NG), Experian (LON:EXPN), Compass (LON:CPG), Bunzl (LON:BNZL) and Worldpay (LON:WPG).
US business sectors that will profit most
According to a study by the University of Pennsylvania US mining companies are likely to benefit from a 60 percent cut in their effective tax rate. This is followed by administrative support and waste management (-47 percent), accommodation and food services (-46 percent) and transport (-41 percent).
Political reality check: the mid-term elections
November 2018 will see the return of America’s two-year electoral cycle with the House of Representatives and one third of the Senate up for election. Since the defeat of the pro-Trump Judge Roy Moore in the Alabama Senatorial election on 12 December, the Democrats have sensed that the tide may have turned in their favour. But the truth is that no one can be sure what will be the electoral mood come next November. My best guess is that Mr Trump will be riding high.
I was interested to hear Tina Brown, the veteran magazine editor who has her fingers on the pulse of American politics, predict recently that Mr Trump will win a second term in 2020. Be that as it may, it is unlikely that the Democrats storming Congress in November 2018 would make much difference to market sentiment. The US markets surged in the 1990s under President Clinton even though he faced resolute opposition from a Republican Congress.
America: the social divide
While corporate America and investors continue to prosper there are reasons to be concerned that this newly created wealth is not being diffused through American society as a whole. In 2016, 42,000 Americans died of opioid overdoses alone, a 28 percent increase on the previous year. Opioids are either prescription pain-killers or far more nefarious synthetic opioids such as fentanyl which is 50 times more potent than heroin. Partly as a consequence of that, US life expectancy fell for the second year running. I regard life expectancy as a very good proxy measure for the economic well-being of a country.
This is a rare but not unprecedented statistic in an advanced country. The US recorded a similar two-year fall in life expectancy after the influenza epidemics of 1962 and 1963. And in 1993 there was a single-year drop during the Aids epidemic. Sustained falls in life expectancy are only normally experienced by countries in wartime. That said US life expectancy has risen from just 70 in the early 1960s to just under 79 today. But that is well short of European and Japanese levels.
A return of confidence will work wonders for the UK markets.
President Trump chaired a symposium on opioid abuse at the White House in October, so it is very much on policy-makers’ radar. Critics will say, however, that there is no coordinated policy on how to reduce deprivation in America.
According to the World Inequality Lab’s World Inequality Report 2018, since 1980 income inequality has increased markedly in North America and Asia, increased moderately in Europe and has stabilised (though at an extremely high level) in the Middle East and Brazil. Between 1980 and 2016, in North America the top one percent captured 88 percent of the aggregate rise in real incomes. In Europe the top one percent captured “only” as much as the bottom 51 percent. This differential is partly explained by the fact that US asset prices have risen faster than in Western Europe. But the underlying message is clear: in the third industrial revolution (aka the communications revolution) inequality has accelerated – especially in America.
Britain: Beyond Brexit jitters
We have now passed beyond the period of maximum post-Brexit uncertainty. 2018 will be the year in which Britain’s role and post-Brexit potential will come more clearly into focus. As it does so there will be a renewed sense of optimism – something so desperately lacking in 2017.
The FTSE-100 hit an all-time high just before Christmas with the markets in festive mood. The Santa rally pushed the index to above 7,600 for the first time. While the US stock markets have posted a succession of record highs during 2017, the FTSE-100 actually had a pretty lacklustre second half of the year, having only exceeded May’s peak in October before retreating again. A return of confidence will work wonders for the UK markets.
Top-performing UK sectors in 2017
Housebuilders. The likes of Taylor Wimpey (LON:TW) have had an excellent year, buoyed by government-funded schemes such as the Help to Buy scheme to help first-time buyers. But they were negatively impacted in December by the government’s clamp-down on “feudal” leasehold practices. Under government proposals housebuilders will not be permitted to sell new-built leasehold homes and ground rents in England will be set at zero. Leaseholders will be enabled to buy out their freeholds more easily. As a result Taylor Wimpey set aside £130 million in provisions to cover potential disputes with leaseholders. Retirement home specialist McCarthy & Stone (LON:MCS), for which ground rents are intrinsic to its business model, lost nearly 10 percent of its stock price as a result of this on 21 December. Berkeley Group (LON:BKG) and Persimmon (LON:PSN) were also impacted.
Online fashion brands. In 2017 fast fashion giant Asos (LON:ASC) and youth-friendly Boohoo.com (LON:BOO) powered ahead. RBS Capital Markets believes that Asos has formidable competitive advantages, not least customer loyalty, which will enable it to sustain its current high levels of growth.
Mrs May: Terminator IV
Mrs May is not only a survivor but we learnt last year that she is indestructible. Nothing can destroy her, like the Terminator. If she falls into a cauldron of molten metal, the little metallic pieces of which she is made will just re-cohere into a functioning android. If she is frozen at a temperature of absolute zero and shattered with a sledgehammer – no problem. Once again, the shards have the ability to find each other and re-assemble themselves. If thermonuclear war breaks out with Little Rocket Man, Mrs May will be found stalking the smouldering ruins, muttering to herself about strong and stable government.
Even her most ardent critics in the Tory Party have understood this – which is why there will be no leadership challenge in 2018 – nor in 2019. So we can expect more steely stares into the middle distance as the trade negotiations with Monsieur Barnier get hairy during 2018.
But, seriously, this is important. One of the reasons why the Phase I Brexit talks stalled and nearly came to grief was because, back in October, the Europeans – who have always been badly informed about the UK – thought that Mrs May was a goner and that they would soon be dealing with Mr Johnson – or something even worse. The European nomenklatura then came collectively to the view that it was better to deal with the devil they knew. The result was that the Phase I negotiations ended on a harmonious theme, with Mrs May receiving applause from the EU-27 leaders at the December Brussels summit. (True, there is a school of thought that this applause was sarcastic – like that for Florence Foster Jenkins after one of her song recitals.)
Why there will not be a second referendum
The Liberal Democrat leader, Sir Vince Cable, is just one of many amongst the ultra-Remainers who wish to scupper Brexit by holding a second referendum. Messrs Blair and Clegg have also been manoeuvring in this direction. Just before Christmas the Lib Dems tried to pass a Commons amendment to the Brexit bill now going through parliament that would have obliged the government to hold a referendum on the final Brexit agreement in December 2018. Those who wish to precipitate a second referendum which they believe would reverse Brexit were emboldened by the government’s defeat in the House on an amendment drafted by Tory Remainers on 13 December.
Labour’s policy on Brexit is in constant evolution but is consistent in that it amounts to doing anything that might discomfort and thus topple the government. (Mr Corbyn really believes that there will be another election in 2018 and that he will win – there won’t be one, period.) In the week before Christmas Labour’s deputy leader argued for a second referendum while Ms Abbott, Shadow Home Affairs Spokesperson, ruled it out.
Certainly, the scarier that Brexit can be made to look, the greater the challenges exaggerated, the more the potential benefits ignored, the greater the chance that the public can be panicked into vetoing Brexit at the very last moment. But to promise a second referendum now would be folly in so far as it would incentivise the EU to offer Britain the worst deal imaginable in the expectation that the British public would reject it. If, on the other hand, the UK commits to leave the Single Market and the Customs Union with no question of a second referendum, the Europeans will come under intense pressure to strike an agreeable trade deal with the UK, given the value of British markets to their exporters.
Moreover, a second referendum would just prolong the agony. In the run-up to such a referendum there would be an additional layer of uncertainty; and if the referendum resulted in a rejection of the proposed deal, that would plunge business into inordinate confusion. Sterling and UK financial markets would undoubtedly suffer.
As the Brexit bill steers through the House of Lords where the Tories are in a minority, there is a significant risk that their lordships will seek to add the provision for a second referendum. But we don’t need to worry. Under the Parliament Act 1949, the Commons can just ignore the House of Lords and pass a bill without its consent one year later.
How Brexit will pan out
It is significant that Phase I of the Brexit negotiations was finally concluded – but nearly foundered – on a form of words which created the right degree of constructive ambiguity. This taught us that most of the trade negotiations in Phase II of Brexit will be about language rather than substance.
On 26 December, Sigmar Gabriel, Germany’s acting foreign minister, said that a smart Brexit deal, but one which takes the UK out of the Single Market and the Customs Union, could be a model for the EU’s relations with, amongst others, Turkey and Ukraine. The period of teeth-sucking and tut-tutting has given way to a more practical mood in Europe where a more Federalist internal agenda is developing by the week. Many Europeans, President Macron amongst them, regard Brexit as the welcome removal of a brake on European integration.
Of course, I do not underestimate the technical complexities of negotiating the fine details of trade in automotive and aerospace components. Not to mention the issue of passporting rights for British banks (though, I shall explain shortly why this is not as big a deal as it is made out to be). But both sides know that mutually acceptable solutions have to be found.
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There will certainly be a transitional or implementation period from 29 March 2019 to 31 December 2020 during which time the UK will have to adhere to all EU regulations and pay all of its dues as before. I do not think that the fervent Brexiteers should get too perturbed about this: Britain has already signed up to the EU budget commitments to end-2020. Further, it is likely that the gross contributions paid by Britain to the EU over this period will be netted off the notional £39 billion Brexit Bill.
That Brexit Bill will come to be seen for what it is: a shibboleth rather than real cash. Come 01 January 2021, the UK will be able to forge international trade deals and to embark on radical new policies in the field of agriculture, industrial policy, environmental protection, animal welfare and healthcare. Rather that become an unregulated country post-Brexit the UK could emerge as the most effectively and humanely regulated country in the world.
All this will gradually become apparent during 2018. A new mood of cautious optimism will displace the extreme apprehension of 2017. Business sentiment will respond accordingly.
Is London Real Estate looking cheap?
While pundits foresee doom for the City of London, if you take the trouble to go down there you will see more cranes than ever. From the observation deck at Tate Modern I counted more than 20 last month. That suggests that the construction companies are bullish about City property even if there is downward pressure on rents – hence the fall of share prices in real estate investment trusts (REITs) and property companies.
Indeed, share prices have fallen so much that opportunistic M&A activity has begun – such as Hammerson’s (LON:HMSO) offering to acquire rival Intu (LON:INTU) last month. The combined group would own 17 of the UK’s 25 biggest shopping centres. Intu’s shares surged by 20 percent though Hammerson’s fell on fears that the combined group would be too exposed to UK retail which is supposedly in structural decline.
Some analysts speak of a “double discount” on UK REITs. Firstly the underlying assets are undervalued; second the REITs are trading at a dramatic discount to Net Asset Value (NAV) per share. For example, Land Securities (LON:LAND) NAV per share was £14.68 on 30 September while its share price just before New Year was 1,000 pence. Less dramatically, for British Land (LON:BLND) the NAV was 939 pence at the end of September compared with a share price as I write of 685.50 pence. Then there is the “triple discount” from the perspective of foreign investors by virtue of the cheap pound.
There is no shortage of foreign interest. Last March the Chinese developer CC Land Holdings paid £1.15 billion for 122 Leadenhall Street (popularly known as The Cheesegrater). That was about 26 percent above the building’s book value and was China’s largest investment to date in UK real estate. About two thirds of the £4.8 billion invested in UK real estate in Q3 2017 came from Asian buyers, according to CBRE.
Similarly, Land Securities sold the “Walkie Talkie” building on Fenchurch Street to a Hong Kong investor for £1.3 billion – an estimated 13 percent above the asset’s book value. Moreover, rental yields remain attractive given current ultra-low interest rates. China’s Cheung Kei Group bought the former London base of Bear Stearns in Canary Wharf for £270 million, representing an initial net yield of 5.2 percent according to Capital Real Estate Partners.
If I am right that we shall enter a calmer, less agonised phase of Brexit in 2018 then UK REITs and property could turn out to be major beneficiaries.
Stop Press: Residential London property. I also note that residential property prices have been softening in the outer London boroughs since the summer including those that will be transformed by end-2018/ early-2019 by the partial opening of the Queen Elizabeth Line (aka Crossrail). From the end of 2018 passengers alighting in the aspirational community of Abbey Wood will be able to reach Whitechapel in eight minutes, Tottenham Court Road in 14 minutes and Heathrow in about 40-50 minutes. (Maidenhead – the fief of Mrs May – will benefit somewhat later.) I do not think that Londoners – or investors – have understood how transformative this quiet infrastructure project – the biggest in Europe, delivered on-budget and on-time – will be. And yet few commentators are talking about it. If you are still not bowed by Mr Osborne’s heavy-handed changes in stamp duty designed to restrain buy-to-let, check out the outer London Boroughs of Bexley and Hillingdon.
UK government finances
I wrote extensively during 2017 about the condition of UK government finances. While the overall picture was somewhat depressing, with the debt-to-GDP ratio edging persistently upwards, there was some heartening news in December. Before Christmas the Treasury announced that public borrowing was £48.1 billion for the first eight months of the financial year. That was the lowest recorded eight-month figure since 2007 – before the Credit Crunch. Tax receipts in November were five percent up on the previous year, with strong growth in income tax and VAT receipts. The best month for tax receipts is January when self-employed people have to cough up for their hard-earned gains. The Treasury is anticipating a beneficent January 2018 – despite the soothsayers at the OBR who, like the old crone in Up Pompeii! foresee Wo, wo and thrice wo!
Analysts think that full-year borrowing by the end of March 2018 is unlikely to be significantly below its budget forecast of £49.9 billion. However, there is a decent chance that, if tax receipts continue on-trend, then new borrowing should fall at a faster rate than the OBR expects. Continued falls in unemployment (now down to a 42-year low of 4.3 percent) mean that more people pay tax and, correspondingly, the state saves in transfer payments, cutting the deficit from both sides.
Of course, the national debt, at about 84.6 percent of GDP, is still uncomfortably high and, as I wrote in my analysis of Mr Hammond’ budget, there is no firm date set as to when the government books will finally balance. But if Mr Hammond could demonstrate a downward onward trend in that metric over 2018-19, the markets are likely to take comfort from that.
You may recall that the OBR was established by Mr Osborne in the very early stages of the Coalition government (2010-15) because, under Gordon Brown, the Treasury had begun to spin its own numbers in a kind of Brownian motion. But what we have today is a bunch of recusant Remainers who are determined to prove that the British economy has no future. They have been wrong, arguably, on every single economic prediction since their inception. It would do everyone a favour if they were quietly put out of their misery.
Position yourselves for a bumper year! Don’t miss out on the Trump boom and the UK bounce. At the very least the UK market will not turn south so long as the US markets continue to head north. You may as well enjoy the party.
I will be explaining soon why I am still cautious about Europe and why I think Emerging Markets will come out of the shadows in 2018 in upcoming articles. 2018 will be a year of opportunity. May you prosper!