Market sell-off, defining moment? And the UK Budget

Every asset class and just about every market across the world has seen negative performance in the last few weeks. Why?

At home, we have the issues of BREXIT and the uncertainty that this brings.

In Europe, we have the challenge of the Italian and the Spanish Budgets. These will force huge pressure on the European community to decide how they are going to manage these economies which are far too far in debt with little prospect of raising enough revenue to meet their budgetary promises.

In Germany, complacency breeds contempt. Despite the amazing miracle of wealth and prosperity that has been generated by the economic machine of Germany, they are beginning to vote against the very things that bought them so much wealth and stability, such that if there is a stabilising force in Europe in the form of Angela Merkel, this may now be a thing of the past.

In America, clearly the issue of mid-term elections is weighing heavily on everybody’s minds and the outcome will very much define the future of both the current president and the economic strategy in the next couple of years. If Congress goes Democratic, but the Senate remains Republican, then Trump survives and pretty much his agenda moves forward. But if both houses go Democratic, then not only does Trump get into huge amounts of trouble, but many of his economic strategies will be curtailed.

China’s economic policy is probably central to the whole of the world. Do they give up on America and refuse to buy its debt? Can the Chinese manage the mountain of debt that they have generated in their local authorities and which has to be unwound or rebalanced? Can the Chinese drive themselves forward through greater consumption and lower savings ratios? Thus, will the Chinese Central Bank come to the rescue of both the administration and effectively the world by unlocking a significant amount of surplus credit, in effect, flooding the market, much as they did in 2009 after the sell-off in 2008 in order to rescue the global economy from disaster?

Are we now at another defining moment?

KMG convened an emergency investment committee meeting at 9.30am on 29th October to review markets, information and consider the future. We looked back over the ten years to see how markets had grown quite dramatically despite very sluggish economic growth.

Markets have expanded as a consequence of a number of different factors, primarily however, it has to be recognised that with very low rates of interest and huge amounts of money being pumped into the system from literally every part of the globe, this has inflated asset prices – be they property, works of art, equities, and of course they have driven up the price of fixed interest and bonds as interest rates have fallen lower and lower.

For the hotspots of the world in the property market, if you want to sell quickly, you now have to accept a significant reduction in price (around London and the south-east, this is about 25%). An awful lot of people predicate their wealth based upon the value of their properties. This could be considered as a defining moment.

Yet, as with other significant property sell-off moments we have seen over the last 30-40 years (the best or worst of them being in the late 1980s when property values fell 25%-35% and took ten years to recover), we suggest that this is going to happen in the hotspots of the world, but that it can probably be digested as people will gently be resigned to a lower level of asset value.

The reason we think that property prices can fall without too much damage is that interest rates and inflation are not going to go up albeit that interest rates will go up slightly, but not in such a way that they will create negative equity by people being forced to sell because they cannot cover the cost of their mortgages. Whilst people will be trapped in their properties for a longer period of time than they may have wished, it probably will not spill over into a significant economic issue.

Moving onto interest rates and the price of fixed interest assets, we suggest that the asset prices will gently decline over the coming few years as interest rates very gently increase. We suggest that in the next 3-5 years, domestic interest rates may have moved forward to somewhere in the region of 3%-4%, albeit that this will be a general and gradual increase in such a way that it does not inflict immediate panic or pain on anybody, but generally allows everybody to get used to the idea of higher interest rates and consequently lower fixed interest values.

The next question you ask is why haven’t they (KMG) moved into cash? What is wrong with cash?

The answer to this question is the same answer that we have given for the last 45 years and that is, which cash?

How long do you hold the cash? When do you time the bottom?

You might not lose capital on cash, but you will not earn any money on cash, in sterling terms. The problem for sterling is as follows. As we sit here with no idea where BREXIT is going, we could well see a hard BREXIT and a dramatic reduction in sterling’s value. This will be particularly bad for a number of different reasons:

1. It will create artificial inflation.
2. It will mean that the value of your portfolio will increase dramatically but the value of your cash will go down.
3. May we remind everybody that we have constantly advised all of our clients to hold at least a year’s spending power in cash at any one time.
4. This was re-emphasised at our seminar in September and Jenna Duffett’s bulletin to you and we believe that we have built in enough cash into our portfolios and we have tried to encourage all of our clients to hold enough cash to cover short-term volatility so that you can ride through the storms that inevitably happen such as this one.

Should you move into other currencies such as the euro, the yen or US dollar? This becomes fraught with difficulty. Just take the euro as a simple example: where does the euro go given the enormous budget issues between the wealthy Germans and the rest of Europe, particularly Italy, Spain and Greece?

Where does the US dollar go with such an irrational president and so many conflicting issues particularly with a trade war with China and the possibility of significant global dislocation in this area?

In Japan, the demographic age wave is unbearable and, quite frankly, Japan shows the model for the future in the sense that they have a debt to GDP of 250% whereas in Europe it is generally in the region of 100%-150%. One has to assume that in the short-term, if the world can cope with the Japanese debt to GDP ratio being so high, therefore, we have some way to go before the situation boils over in Europe or America.

An alternative value transfer system

We have constantly made you aware of block chain technology and crypto-currencies.

We have no idea how this will manifest itself, but we are absolutely certain that these issues are going to come to the fore over the next 5-10 years. If we move into some alternative form of value transfer system, then we see significant issues for debt and equities. On the one hand, debt could easily collapse in value and disappear. On the other hand, equity will move through the issue and will increase in value albeit that we have no idea what unit of value equity may be priced in.

History constantly tells us that a world with too much debt has to rebalance at some point and this may therefore be the defining moment for the world albeit that the rebalancing of the globe from debt to an alternative value transfer system could take 10-20 years.

In conclusion, the committee agreed the following:

• there will not be a cataclysmic event in the short-term
• we will drift into a new norm in the longer-term of possible lower values
• stock picking and asset allocation will be essential
• we must all accept lower investment returns in the future but not necessarily a real reduction in our standards of living because technology enables us to live a better quality of life for less money anyway
  markets will remain very volatile
• the political uncertainty will continue but we are not sure that politics has as much effect upon global economic affairs as it has done in the past through history
• most importantly, we remain long-term investors and we expect all of our clients to have enough cash to cover short-term emergency requirements so that they can cope with a very volatile economic environment which will manifest itself in the foreseeable future.

The Budget

The Budget in the UK did not really throw out any surprises.

Spread sheet Phil as The Chancellor is referred to, has relaxed the fiscal noose and slightly wounded some of Labour’s aspirations, he has also subtly reminded the EU that we can make the UK a reasonable place to live and work with less burdensome taxation. (Is it electioneering, we shall see).

He certainly appealed more to his core voter base, which was once the basic building blocks for the Labour Party, and which has now transferred allegiance. Increasing the minimum wage expanding the tax allowances will benefit the less well off in society who are in work and apparently all “drive white vans”.

Many of the recommendations made, however, were fairly minimal given the funds available to him and the impact that we see will be small meanwhile much of the cuts to welfare provision remain painful, especially the roll out of universal credit. But then again one wonders if in the end universal basic income will take over for all anyway!
Sterling declined temporarily in value because the budget puts more strain on the economy to both pay its way and pay down its debt.

As always, the devil is in the detail and it will be some days before we know of the hidden agenda which may or may not exist within the published document.

Of great benefit to markets of course is that a lack of interference and change provides greater stability for investment and growth, which would have been more challenging had there been a radical overhaul of the tax system. The radical overhaul gets ever closer because of the entire change in the structure of society, this is shown in the very tentative move towards taxing digitisation and the behemoth of Facebook, Amazon et al!
In terms of investments and returns the budget is broadly supportive and should aid the thoughts above.

Conclusion

Our view for now remains to sit tight. If you have any concerns and need to raise cash urgently, please do let us know, otherwise we will continue to monitor events as they progress this autumn.

October 2018