Metastable markets at risk from impact of US, UK political stalemate

UK election Jun17We are living in very uncertain times, where the only certainty is that there is no “business as usual” option for the future.  One sign of this is that the extraordinary has become ordinary :

□   The FBI appear convinced Russia’s government targeted last year’s US elections: US President Trump and his former FBI head have since accused the other of lying about the issue
□   UK premier Theresa May has just lost an election she had expected to win by a landslide, and is now engaged in a probably futile attempt to remain in power

We have not seen political chaos on this scale since the 1970s.  Yet unlike the 1970s, markets continue to bury their heads in the sand, in the mistaken belief that the central banks will always be able to ensure that prices never fall.

The problem is two-fold:

□   Most investors and company executives grew up during the BabyBoomer-led economic SuperCycle. They have never known a world where growth disappointed, and where political stalemate led to major economic crises
□   Central bank policies have made the underlying situation worse, not better.  They have artificially boosted the value of financial assets (stocks, houses and commodities) whilst creating vast amounts of debt that can never be repaid

Even worse is that a generational divide has opened up in both the US and UK, as most assets are owned by older people.  Younger people instead find themselves burdened by high levels of student debt, and facing a future where weekly earnings are no longer rising in inflation-adjusted terms.

KEY AREAS OF TRUMP’S AGENDA HAVE FAILED TO MOVE FORWARD
It was clear when President Trump came to power that we had reached the end of “business as usual“. He immediately set about creating major disruption in global trade patterns:

□   He cancelled the TransPacific Partnership which would have linked 11 Pacific countries with the USA
□   He also notified Congress of his intention to renegotiate the North American Free Trade Agreement
□   More recently, he announced his intention to withdraw from the Paris Climate Change Agreement, COP-21

Unsurprisingly, push-back is now developing against these dramatic changes.  On COP-21, powerful opponents such as Michael Bloomberg have begun to co-ordinate moves by several key states, cities and companies to instead “do everything that America would have done if it stayed committed” to the Agreement.

Trump’s other major policy move – the lifting of restrictions on the development of fossil fuels – is also seeing push-back, this time from the markets.  Oil prices are already back to pre-election levels, and are likely to go much lower as new US production comes online. 

Trump’s position is also weakened by his failure to recruit a large team of highly skilled people, capable of promoting his agenda with all the relevant stakeholders.  So far, he has only nominated 83 people to fill the 558 key positions in his Administration that require Senate confirmation.  In the Dept of Commerce, only 7 of the 21 key positions have been nominated; in Energy, only 3 out of 22; in Treasury, only 10 out of 28.

As a result, the US now seems likely to face political stalemate.  Trump clearly has a mandate to push through his changes. But every day that passes makes it less likely that his key policy objectives – healthcare/tax reform and infrastructure spending – can be implemented.

The problem is simple – every new President has only a short “window of opportunity” to implement his policies, as their post-election momentum soon starts to disappear. By Labor Day (4 September), legislators are refocusing on next year’s mid-term elections. Their ability to make the compromises necessary for major legislation soon disappears, once the “losers” from any change make their voices heard.

MAY’S ELECTION FAILURE CREATES AN OPENING FOR CORBYN
Last Thursday’s election result confirmed my analysis back in October that:

In the UK, where most pundits regard the populist Labour Party leader, Jeremy Corbyn, as unelectable due to his radical socialist and pacifist  agenda, it would only take a breakdown in the Brexit negotiations for his chances of gaining power to rapidly improve.

The breakdown duly occurred with May’s decision to adopt a “hard Brexit”.  May, like Trump, relied on a small group of advisers and failed to recruit the team needed to push through her ambitious agenda of total EU withdrawal.  The result, as I noted last month, was that the “UK risked crashing out of EU after election without a trade deal“.

This stance created fertile ground for Corbyn as he mobilised large numbers of young people to vote for the first time. They quickly realised that their future was at stake, given that the Brexit negotiations are due to start on June 19.

May will clearly try to hang on – but she is unlikely to succeed for very long.  Corbyn’s move to propose giving EU citizens full rights after Brexit could easily be the straw that brings May down, as leading Tories such as Ken Clarke and others would no doubt vote with him.

As in the US, political stalemate is likely to develop.  Brexiteers no longer have a mandate for a “hard Brexit”, where the UK would leave the EU without access to the Single Market and Customs Union.  But neither can Remainers easily reverse the formal EU exit process, which will see the UK leave the EU by March 2019.

MARKETS ARE IN A METASTABLE STATE
Markets cannot continue to ignore these developments for much longer.  They are in what scientists would call a metastable state.  The detail of the next move is uncertain – and the only certainty is that the status quo is untenable:

□   There is no going back to the SuperCycle: the Western world faces a demand deficit due to its ageing population
□   Equally, there is no obvious and easy route forward, until policymakers focus on the “impact of the 100-year life

As a result, markets will soon be forced to rediscover the negative impact of political stalemate.  Probably Winston Churchill’s famous comment after the Allies’ victory at El Alamein in 1942 best describes the position:

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

UK risks “crashing out” of EU after election without trade deal

Car

 

Yesterday, senior EU negotiators warned that “the chances of Britain crashing out of the EU without a new (trade) deal were now “over 50%””.  Clearly, therefore, the UK’s preparations are not going well.

Instead of building trust, the UK’s Brexit Secretary, David Davis, seems to think that threats – such as promising “the row of the summer– are the best way to open discussions.

I have taken part in major trade and contract negotiations around the world.  Based on this experience, I believe his strategy is very unlikely to succeed.  It risks instead leading to a populist-style “Battle with Brussels”, which the UK will lose.  The UK will then crash out of the EU – with no deal on trade – long before the March 2019 deadline.

PREMIER MAY IS IGNORING HER OWN WARNING LAST YEAR
My key concern is that premier Theresa May seems to be ignoring her own warning before last June’s referendum:

The EU is a single market of more than 500m people, representing an economy of almost £11tn ($14bn) and a quarter of the world’s GDP.  44% of our goods and services exports go to the EU, compared to 5% to India and China.  We have a trade surplus in services with the rest of the EU of £17bn.  And the trading relationship is more inter-related than even these figures suggest.  Our exporters rely on inputs from EU companies more than firms from anywhere else: 9% of the ‘value added’ of UK exports comes from inputs from within the EU, compared to 2.7% from the United States and 1.3% from China….(my emphasis)

I am not alone in my fears. UK industry is becoming very worried about what may happen.  Paul Drechsler, President of the Confederation of British Industry (CBI), spelt out the key issue last week  – the need to maintain access to the Single Market and Customs Union.  He described the journey of a computer chip made today in Cardiff’s tech hub:

“The chip is bought by a company in Germany. The metals inside it are sourced from South Africa and Turkey, using free trade agreements the UK has through its EU membership.  Some of the plastics inside it are processed in Poland and Spain. Engineers from France, Croatia and Hungary worked alongside Brits in Cardiff to design it.  When finished, it is packaged by a worker from Bangor, Wales and delivered to the port by a driver from Slovakia.

“The chip has been made to European standards, its design protected by a Europewide trademark.  It was insured with a financial package covered by EU passporting and, when incorporated into a machine and put in the shop, it will meet Europewide levels of consumer protection.

“In other words, for that chip, and the British company that makes it, to remain as competitive as today we need: three new trade deals, free movement of EU citizens, three new sets of internationally approved regulatory and copyright standards and an agreement on EU financial services passporting.”(my emphasis)

A hard Brexit, without access to the Single Market or Customs Union, will not just impact the UK. As the CBI example confirms, today’s complex and extended supply chains mean that companies across the EU27, and around the world, will find their trade disrupted.

RULES AND REGULATIONS ARE AS IMPORTANT AS TARIFF BARRIERS TO MOST COMPANIES
Many in the UK chemicals industry – the UK’s largest manufacturing export earner – are also very worried.  Its largest customer, the car industry, is totally dependent on global supply chains and just-in-time delivery, as the chart shows. Going back to a pre-Single Market world of tariffs, customs barriers, endless form-filling and border delays will lead to major uncertainty and loss of business.

And, of course, tariff barriers – although important – are not the only issue. The future role of the European Court of Justice, and the rules and regulations under which products are sold, are even more critical, as a new survey by the British Coatings Federation confirms:

“Over three quarters of our members said that a separate UK chemical regulatory system would be bad for business. Maintaining regulatory equivalence with key EU regulations (REACH, CLP and BPR) through continued relations with institutions such as the European Chemicals Agency is essential to ensure we have a strong UK manufacturing base that can import chemical raw materials from Europe, and export finished goods such as paints, coatings printing inks and wallpaper without being at a competitive disadvantage.”

BREXIT RISKS ARE BEING IGNORED IN THE UK ELECTION CAMPAIGN
Given the criticality of these issues for the economy, they should be the major topic of the current election campaign. But instead May’s election manifesto simply promises:

“As we leave the European Union, we will no longer be members of the single market or customs union but we will seek a deep and special partnership including a comprehensive free trade and customs agreement.”

She seems to expect the Brexit negotiations to follow the pattern of the Treaty of Lisbon in 2014:

  Then the UK appeared to “opt out” of key domestic and legal policies to pacify the Eurosceptic tabloid media
  Behind the scenes, however, it negotiated a special Protocol 36
  After signing the Treaty, the UK immediately “opted back in” to many of the policies via Protocol 36

But it is very hard to see how this can happen with Brexit, as EU Commission President Juncker warned last month.

I am therefore not optimistic about the outcome of the talks.  I correctly warned – over a year ago – that Brexit was likely.  Having followed developments since then, I find it hard to believe the EU 27 will allow May a back-door re-entry via a new Protocol 36-type deal, after a “hard Brexit”.  This seems a totally unrealistic objective.

I hope I am wrong.  But if I am right, the current UK government strategy means there is no “business as usual” option for the vast majority of UK companies – or for many EU 27 and non-European businesses.  I fear, as I have warned since March 2016, “Brexit will hit UK, Eurozone and global economies“.

 

London house prices face perfect storm as Brexit risks rise

London houses May17The UK goes to the polls on 8 June in a surprise General Election.  And premier Theresa May has clearly decided to base her campaign on a ”Who governs Britain?” platform, as she highlighted when launching her campaign last week:

“Britain’s negotiating position in Europe has been misrepresented in the continental press, the European Commission’s stance has hardened and threats against Britain have been issued by European politicians and officials. All of these acts have been deliberately timed to affect the result of the general election that will take place on June 8….there are some in Brussels who do not want these talks to succeed. Who do not want Britain to prosper.”

In reality, of course, all that has happened is that Brussels is behaving exactly at Theresa May herself forecast, when campaigning a year ago for the UK to Remain in the EU:

“In a stand-off between Britain and the EU, 44% of our exports is more important to us than 8% of the EU’s exports is to them….The reality is that we do not know on what terms we would win access to the single market…It is not clear why other EU member states would give Britain a better deal than they themselves enjoy. 

May’s rhetoric will no doubt give her a large majority, given the weakness of the Labour opposition.  She has also promised to be “a bloody difficult woman” during the Brexit negotiations that follow the election. But what is good for an election win, may not be such good news for London house prices.  These are at all-time record levels in terms of the critical price/earnings ratio, and were already heading into an inevitable downturn as the City AM chart shows:

  Massive over-building at the top end of the market means there are now 59k high-end apartments under construction in London, yet annual sales of new-build flats are just 6k
  Sales have also been hit by the hike in purchase tax (stamp duty) to 10% above £925k ($1.2m) and 12% on purchases over £1.5m
  The UK’s 2 million ‘buy-to-let’ landlords, most of whom are in London, have also been hit by a combination of a higher tax take on their income and tighter borrowing criteria for mortgages
  China’s capital controls means its buyers have had to pull back, as it becomes more difficult to move money overseas.  They have been the largest buyers of residential property in central London

Now this downturn could well become a perfect storm, as May’s “battle with Brussels” risks an exodus of highly-paid finance and other professionals from London.  As the BBC reports: “More than one million people work in the financial services sector in the UK and it pays over £70bn a year in taxes to the government, 11.5% of all receipts.

FINANCIAL SERVICES ARE PREPARING TO LEAVE LONDON 
The CEOs of the world’s 2 largest investment banks have already warned of difficult times ahead.

  JP Morgan CEO, Jamie Dimon, has warned:  “The clustering of financials in London is hugely efficient for all of Europe. Now you’re going to have a declustering which creates huge duplicate costs which is expensive to clients, but we have no choice.”
  Goldman Sachs CEO, Lloyd Blankfein, has highlighted the risks caused by uncertainty over the terms of the UK’s exit: ”Without knowing how things will turn out we have to plan for a number of contingencies,” Mr Blankfein said about possible job losses. “If there is no period of time to implement whatever changes are brought about in a negotiation, we may have to do things prematurely and we may have to do a range of things as a precaution and take steps.”

Unsurprisingly, buyers are starting to sit on their hands and waiting to see what happens, as The Guardian reports:

“London estate agents have begun to offer free cars worth £18,000, stamp duty subsidies of £150,000, plus free iPads and Sonos sound systems to kickstart sales in the capital’s increasingly moribund property market. The once super-hot central London market has turned into a “burnt-out core.”

How much will prices fall, and how long will it take for prices to bottom?  These are now set to become the key questions at London dinner-parties.  Logic suggests prices will need to fall at least 50% to bring them back to more affordable levels.  And the pain is likely to stretch out over years, as leading buying agent, Henry Pryor, has warned:

In my 28 years in the property business, we have done this twice before, and each time it takes around five to seven years before things recover.”

We must all hope that May will use her potential landslide election win to quickly reverse her recent rhetoric, and return to the common sense positions she staked out before the Referendum.  It is not too late for her to agree to remain in the Single Market, the Customs Union and accept the jurisdiction of the European Court of Justice.

Without such a move, London home owners will face a perfect storm as the financial services industry “de-clusters” to Frankfurt, Paris, Brussels, Dublin and Amsterdam next year.