A broadly positive week for the developed market equity indexes. For the week the S&P gained +0.8% while the small-cap Russell 2000 was up +2.5%. Only emerging equities lagged, losing -1.1%. An upcoming meeting between the U.S. and Chinese leaders is leading to jitters about a possible trade conflict. Chinese mainland equities lost -0.7% while Hong Kong stocks were down -1.9%.
Bond yields were unchanged and most bond asset classes did very little. High-yield stands out with a +1.1% gain for the week.
Econometric Models Work Until They Don’t
In the realm of economic data, the Commerce department updated their estimate for 4th quarter GDP. Growth was now +2.1% during the quarter, up 0.1% from the last estimates. Probably the best news in the report was the fact that personal consumption grew +3.5% versus a previously reported +3.0%. The consumer is doing pretty well, and they are also growing more confident. Consumer confidence hit a 16-year high in February (see below).
What this all means for growth in the first quarter is tough to say though. The two most widely watched estimates are giving a very different read. The Atlanta Fed is pointing towards a disappointing +0.9% growth number (red line below). The New York Fed thinks +3.0%. That’s a gap big enough to drive a truck through!!
But we shouldn’t be shocked that economists don’t agree. We probably should be more worried if they were on the same page. However, we think a key statistic from the GDP report was the trade number. As you can see below, trade subtracted 1.7% off the 4th quarter GDP number (imports were much higher than exports). This is the biggest subtraction since 1990.
Why is this important? It could set the stage for trade negotiations. President Trump is meeting with Chinese President Xi Jinping next week. At Mar-a-Lago of course.
Is the Trump Trade Simply a Bet on a Profit Rebound?
Ever since the election traders have been playing the Trump trade. Simplistically, this entails buying stocks (especially small-caps and emerging markets), buying the dollar, and selling bonds. However, over the last couple weeks this bet has started to started to falter, especially for small-caps. As the odds of the health care bill going down in flames increased, investors turned skittish. The line of thinking is that a failed health initiative lowers the odds of a tax deal. And to the extent the Trump Trade hinges on tax reform, this isn’t good for the markets. At least that’s how the line of thinking goes.
Dig a little deeper and this view might be overly pessimistic. One key feature of the last few months is that business revenues have rebounded noticeably, as you can see below. The blue line is total sales while the red line is S&P aggregate revenue.
Revenues were hit in 2015 and 2016 as commodity prices plunged. However, prices stabilized in 2016 and this is feeding through into revenue growth and will ultimately boost S&P earnings.
An early look on earnings came with this week’s GDP report. It shows that the profit component of GDP grew by over 9% in the fourth quarter last year, the fastest rate since 2012. This is a notable turnaround after five consecutive quarters of decline.
Of course, the President has nothing to do with the rebound in commodity prices and the subsequent increase in revenues (but I’m sure he’ll take credit). But it is quite possible that the market has rallied on something other than hopes for tax reform over the last few months.
The Clock is Ticking on Article 50
Back in October Theresa May promised to invoke Article 50, the legal procedure for leaving the European Union, by the end of March 2017. She hit her goal. On Thursday she sent a physical letter (how quaint!!) to the president of the European Council. The clock is now ticking. The U.K and E.U. officially have two years to hammer out a deal, but it is likely to be just 18 months if they hope to get anything passed by the respective parliaments.
There is a lot of talk about this being one of the most complicated negotiations in history. The natural reaction is to chalk this up to hyperbole, but the more you read about what needs to be done in the next couple years, the more daunting things look. The Financial Times laid out a three-step process that I’m going to partially plagiarize.
Step #1 – Withdrawal Negotiations – 2017
There are a couple key issues:
- Like any divorce money will ultimately change hands. In this case it will be the U.K paying alimony to the E.U. There is speculation this could run as high at $60 billion, but U.K. estimates are naturally lower. The $60 billion number isn’t insurmountable, but simply sending money back to the E.U. will be politically awkward. The Prime Minister could find it difficult to explain to Leave voters why they are writing a big check.
- Citizen rights. This entails negotiating the terms regarding foreign nationals. There are roughly 1.3 million UK citizens living in Europe and 3.2 million EU citizens in the UK. It isn’t clear if they will retain the right to reside, work, claim free healthcare and draw pensions going forward.
Step #2 – Future Relationship (January to June 2018)
How will the U.K. work with Europe after the divorce? By way of background, the E.U. single market is based on the four principles of free movement of goods, people, services and money. This means member states can trade freely within the single market without having to pay tariffs while operating under shared rules and standards.
The U.K. wants to ditch the free movement of people part but keep as much of the other three as possible. Angela Merkel and other EU leaders have said there can be no compromise on any of the four principles. This is the main challenge for the UK – how to retain access to the single market and end freedom of movement.
The EU will be loath to compromise lest it encourage others to leave. Key questions that need to be resolved include:
- What will the future trade arrangements look like? Size of tariffs, non-tariff barriers, etc.
- Will UK banks still have access to European markets? How will different regulatory regimes be handled? Who supervises what?
- The U.K. plays a key role in the E.U.s security regime and has access to a range of organizations and measures that help fight crime and terrorism. For example, since 2004 the European Arrest Warrant scheme has been used to extradite more than 1,000 criminals to the UK and has allowed the UK to extradite 7,000 criminals to other member states. Will this continue? On what terms?
- And then there are border controls. The Washington Post’s captured the issue nicely:
“In contrast, the fate of border controls, especially the sensitive Northern Ireland land border, is one where recent warm words in the political realm belie a number of tough practical challenges. The British and Irish governments are adamant that they do not wish to see any border controls introduced that would jeopardize the Northern Ireland peace process…The trouble is that if the UK is outside the single market and customs union – as May has insisted is inevitable – then the land border between it and the rest of the EU takes on an economic and legal importance that may be impossible to ignore.
Whether, as some hope, there are technological ways of introducing a degree of customs enforcement and migration checks without a physical border post remains to be seen. The alternative would be to treat Northern Ireland as if it were still in the EU, or the republic as if it were part of the UK – neither of which are likely to help the peace process.”
And of course there is the Scottish question.
Transition (July to October 2018)
This refers to the question of who will enforce the agreed upon rules. As the FT notes:
“A British red line is to leave the jurisdiction of the European Court of Justice. The EU is adamant that benefiting from participating in the single market requires EU rules, EU supervision and EU enforcement. It will demand that the sole authority of European courts to interpret rules is maintained.”
This is a thorny issue. Prime Minister May needs to be able to sell this deal as escaping the yoke of European bureaucracy. If she is tied to the European Court of Justice she will have a rebellion on her hands within her own party. It would means going into the next general election without keeping her promise of severing all ties, but it could be a necessary compromise if no lasting trade deal is in place.
One point the FT didn’t touch on is the process of actually approving the deal. If negotiators do reach a deal, all agreements between the two sides must be subject to ratification by the European and Westminster parliaments. But at least the provisions of article 50 allows for the agreement on departure to be subject to qualified majority voting, both among EU governments and MEPs. There is little danger of a rogue protest from an individual member state disrupting any hard-won deal at the last minute.
When it comes to trade, however, EU law insists on a much wider consultation for any deal deemed to be affecting both national and European institutions. The need to secure support from every national parliament in the EU, including some regional ones, would be a huge obstacle to British hopes of securing a generous trade deal and will be fought at all costs by its negotiators.
Furthermore, E.U. law says that any trade deals with non-EU members can’t be started until the UK has left the EU. This means that the UK can’t begin negotiating with the Trump administration until March 2019.
What are the odds of no deal?
This is going to be tough deal to put together in roughly 18 months. There is a real risk that no deal is reached.
As The Economist notes:
“No deal means reverting to trade on World Trade Organization terms. As Open Britain, another think-tank, notes, this implies not just all of the EU’s non-tariff barriers, but tariffs of 10% on cars, 15% on food and 36% on dairy products. It would end Britain’s access to the EU’s trade deals with 53 other countries. Last year the Treasury said this option would reduce GDP by 7.5% after 15 years. The House of Commons Foreign Affairs committee recently warned against the no-deal option.”
And all of this assumes that the Prime Minister stays in power. Her working majority is just 17. Hardline Brexit supporters in the Conservative party will howl if she gives much ground to Europe. The Economist again:
“In the end, however, her biggest problem may not be with her opponents or with her EU partners across the negotiating table. As so many previous Tory prime ministers have found, it will be with her own backbenchers. Hardline Brexiteers are ready to denounce any compromise in the negotiations as a betrayal. Mrs. May has raised their expectations, as well as those of voters, about the benefits of Brexit. When it becomes clear that there are costs instead, she may find her high popularity ratings fast withering away.”
Have a good weekend.