Richard Buxton: We may be heading towards a soft Brexit with a soft landing

By Richard Buxton

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Nov 23, 2018
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Why having a little fear is not a bad thing 

The wild ride in asset prices at the start of the fourth quarter may have left some investors fearing the worst and wondering about the direction of financial markets.

Treasury yields surged and stock markets around the globe sold off dramatically. October was the worst month in six years for global stocks. The impact of central banks unwinding their extraordinary largesse, slowdowns in China and emerging markets, and trade war ructions spooked the market.

For some commentators, this signalled the end of the long bull run in equities.

My view is different, however. A little fear isn’t a bad thing.

October brought a healthy shakeout in equity markets and a breaking of some momentum trades. We took the opportunity to top-up some of our holdings. The scale of the drop in certain stocks and sectors suggests that most of the damage is done. Last month’s decline may have helped us on our way to a better place. We could even see a rally into Christmas.

It’s true that in Europe, some economic indicators have been weak. We believe that this is a temporary situation partly explained by underperformance in the car market due to the introduction of some bulky new rules on fuel consumption.

The scale of interest rate rises is significant given how low rates have been for so long. The amount of money being withdrawn from the market by central banks is beginning to exceed the level injected. Unwinding all of this was never going to be easy.

The US Federal Reserve will follow the data, and we expect this to show a weakening in interest rate-sensitive industries such as housing and autos.

Indeed, this has already begun. The Fed can’t ignore this. As the impact of higher rates on these industries becomes more pronounced, we believe the US central bank will begin to change its rhetoric. The language associated with a rate increase in March is likely to be more dovish.

We expect financial markets, which have been sceptical of the Fed’s plan for four rate hikes in 2019, will sigh with relief and embrace a moderation in economic growth – albeit with some volatility for risk assets. This should be seen as “the pause that refreshes” the US economy and steers clear of a recession in 2020 that is forecast by many economists but which I don’t see happening.

There’s no sign of a Treasury yield-curve inversion that would signal a recession, nor are there big worries to be seen in investment-grade or high-yield corporate bond spreads.

All of this assumes that inflation will continue to remain in check.

Closer to home, our core view remains that the UK will not crash out of Europe without a deal. It may take a while to wrap up a deal, but it is in no one’s interest – neither the UK Parliament nor the EU – to fail to reach an agreement.

Just to be sure, the May government has provided incentives in the form of increased spending on the NHS and other services while abandoning its plan to balance the books.

Chancellor Philip Hammond is telling Tory backbenchers if they support a Brexit deal, he will spend money in their constituencies. It’s a post-Brexit dividend.

Government figures showed that the deficit has been falling much more rapidly than expected, and this gave the chancellor the opportunity to spend the additional money.

He probably has enough kept in reserve to spend in the case of a difficult Brexit.

The Conservative Party’s narrative seems to be that it can increase spending without raising taxes, while Labour will spend more but will raise taxes to do so.

By the way, running an annual deficit of around £20bn in a budget of £2trn, as the government is proposing to do, amounts to something like a rounding error, and the financial markets will be comfortable with funding this.

The UK economy has picked up nicely after its first quarter lull, and we would expect the Bank of England to be more active as the March Brexit deadline approaches. A rate rise looks likely in our view.

There will be patches of turbulence here and in the US but our core view remains that we are heading for a soft landing and a soft Brexit. All in all, that is a pretty good destination.

Richard Buxton is head of UK equities at Merian Global Investors

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