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President Trump and Negative Yields: Watch out

Pascal Blackburne & Luc Synaeghel 2019-08-01

How the picture can change in just a month. After “promising” at the late June G20 summit to allow trade talks to resume and not impose any new tariffs on goods imported from China, President Trump abruptly reversed course – one day after the Federal Reserve announced its first rate cut in over a decade.

Exactly what happened during the recent trade meeting in China is unclear, but the result was that the talks were cut short and it now really looks like “game over”, at least for the time being. We consider this to be very bad news. Worse, it is not only global economic growth that is at risk, but also geopolitical stability. The demise of the 1987 treaty with Russia on mid-range nuclear missiles is but the latest example of the US pulling out of its multilateral engagements, since President Trump came into office.

And then there is the issue of financial stability. History tells us that when central bank policies become increasingly politically-driven, financial stability comes under pressure. The current US domestic situation did not warrant a rate cut in our view, with both parts of the Fed’s mandate (full employment and controlled inflation) duly attained, and it seems like Chairman Powell surrendered to President Trump’s numerous tweets demanding lower rates. In fact, and to the extent that it was a form of semi-measure, 25 basis points “only” and no clearly indicated path for further cuts, the Fed’s decision may back-fire economically, sustaining a “wait and see” approach in terms of consumer and corporate spending. Of course, keeping rates low for longer (forever?) also serves to please debt-laden governments, by limiting their interest outlays and enabling them to run ever higher deficits.

Unfortunately, persistently low/negative rates have undesirable side effects: the mounting inequalities that the Fed is now openly mentioning, but also “unfair” competition by “new economy” companies. Traditional businesses are facing difficult times, not by means of the usual “creative destruction” process but because of subsidised financing. Put differently, the ever-flowing spigot of cheap money that new, often still loss-making, ventures are readily able to access, with private equity funds also awash with capital, is enabling them to exert undue pressure on more traditional (but otherwise healthy) business models.

What course of action can investors take in such an unpredictable world? In effect, they are forced to choose between accepting a foreseeable loss of purchasing power or putting their capital at risk in the hope of achieving a return that, at least, offsets inflation. But markets will be volatile – vulnerable to Presidential tweets, geopolitical developments, but also an earnings season that could prove difficult for a number of companies.

Investors should not be blind to the risks involved in chasing yields in a world of negative interest rates, be it credit or duration risk. We believe a prudent approach remains warranted for the time being on their fixed income investments. On the equity side, while overall valuation can be considered as rather rich, we still see opportunities in some under-invested and under-researched market segments offering very appealing risk/return profiles. We tend to position our portfolios accordingly.

Vigilance, discipline and patience will be needed.

Update on european politics and corporate earnings

German Long Term Bond Rates vs Inflation

germany yield vs CPI
Source : Bloomberg

In Europe, following the May elections, negotiations have been concluded for the top positions – with France and Germany sharing the pie. President Macron, in particular, appears to have played his cards well, placing a close ally of Angela Merkel, Ursula von der Leyen, at the helm of the European Commission in order to secure French leadership of the European Central Bank (which, incidentally, also looks set to become more politically-driven, Ms. Lagarde not being an economist by training). The French President was also instrumental in having his Belgian fellow Liberal Charles Michel nominated as head of the European Council, and France’s victory will be complete should Michel Barnier, currently EU Chief Negotiator for Brexit, become the region’s Minister of Foreign Affairs.

That said, the nominees for the top 2 EU functions (Commission and Council Presidents) do not appear to be particularly strong politicians, which could disadvantage Europe during the coming years in this world of increasingly aggressive (not to say authoritarian) leadership elsewhere. Russia, China and Turkey obviously spring to mind, but in the US too there is matter for concern. Relying on the “checks and balances” in the political and judicial system to prevent the Trump Presidency from getting out of hand now looks to have been somewhat optimistic. And not only do his odds of re-election in 2020 appear high, but the US President is said to be looking into the possibility of a third mandate, which would be contrary to common law but seemingly not the US Constitution…

Last but not least, a word on corporate profits as the 2nd quarter reporting season unfolds. Albeit slowing down, global economic growth remains positive. But that is not to say that an earnings recession cannot take place – indeed we are perhaps at the tipping point. The reason is that corporate investments are always made with a view to future growth. When that does not materialise, which is the risk in a late-cycle environment, and today even more so because of the trade and geopolitical situation, companies find themselves saddled with excess capacity that has to be written down, hurting earnings. Reported results for the April-June period may still meet expectations, but we worry that warnings about future quarters will be issued, particularly in the production space (the services sector being more resilient initially).

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