- The Big Conversation
- Episode 2: UK election fiscal impact for markets worldwide
How the UK election could pull the fiscal trigger for markets worldwide
Published on: November 6th, 2019 • Duration: 13 minutes
This week we focus on the global knock-on effects of the UK election - including implications for the dollar and bond yields. The market chatter explores a potential surprise inflationary boost towards year-end and whether gold will pop again. And the whisper is around what Sweden might be telling us about the economic future for Europe.
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[00:00:03] You probably know that on Thursday, the 12th of December, 2019, the British electorate go back to the voting box to try and pick a new government for the third time in four years. The outcome of this election could have some surprisingly profound impacts on both asset prices and how policy makers the world over are going to respond. And that is the big conversation.
[00:00:28] The current polls have the conservatives with around about 37 to 39 percent of the vote and Labor and about 27 to 29 percent of the vote. So that looks like a relatively healthy lead for the Conservatives. Now, of course, the backdrop to all of this is Brexit and the Brexit negotiations are in many ways what has led us to this point. And developments in the Brexit negotiations towards a deal has been one of the drivers of asset prices, particularly the pound. And when it looked like a Brexit deal was in the pipeline, the pound went from 1.22 to 1.30. Then we hit this impasse. And as a result of that impulse, we've ended up with a new election as it currently stands. It looks like the Conservatives have a relatively healthy lead, but as has been seen before, a relatively healthy lead can be quickly whittled away and even having a very large number of votes doesn't necessarily translate into more seats. The Conservatives got 5 percent more votes in 2017 versus 2015, but they got 13 fewer seats. So there is still a lot of uncertainty in 40 days is a very long time in British politics. But what the markets think and that in some ways is key. Currently, markets are pricing in the expectation that the current Brexit deal gets done on the thirty first of January, which implies that the conservatives are probably going to win with a majority. Now, that would imply that there is more upside in sterling in the pound. It's moved from 1.22 to 1.30 on expectation of the deal, but the deal has not yet been done. It could probably move to 1.35 or 1.40. If the conservatives do indeed win and win with a reasonable majority. Now, when we look at volatility and we're looking at two months to three month volatility, woman volatility has dropped a lot, but that's before the election takes place. It's still relatively elevated in the two to three month bucket. Well, that's basically saying is there's uncertainty. But it also implies that Sterling could reach those post Brexit highs around the 1.40 level. Now, that has some major implications for global markets. When sterling rallied, the dollar fell. And when the dollar fell, we had that reflation re expectation across global risk assets. Now, although sterling is only a small part of the global system, if it has a big move, it will impact this risk mentality. So if it moves to 1.40 very rapidly between now and through December the 12th and the election, then that could actually have quite a positive impact on global risk assets. It could have a positive impact on European equities, particularly the DAX. The DAX is the reflation index. It's a global growth index and it broke out to the upside when the dollar fell. Similarly, footsie, unfortunately, actually underperforms when sterling goes up because the footsie earns a lot of its earnings in overseas markets and brings them back to the UK and turns them into pounds. If you have a weak exchange rate, you have more pounds, for the Footsie as an index love's a weak pound. So when the pound rallies, then actually the Footsie will underperform. So for global investors, you should be looking at Germany and potentially Europe as a whole versus the UK because the Footsie might actually underperform in an environment where the Conservatives win a majority and the pound rallies. Perhaps more importantly, though, is on the fiscal side and fiscal side is where it becomes really interesting for global markets. The Conservatives historically have been in the austerity camp. They have been reticent to spend too much. But today, the expectation for the Conservative Party to spend is almost the same as that of the Labor Party. A company called Resolution Foundation recently suggested that the Conservatives would spend up to about 41 to 42 percent of GDP within the next four or five years versus Labour around about 43 percent. And this compares to a pre 2008 level when we had the financial crisis of around about 37 percent. And it's more in line with what we saw in the 1960s and 70s and early 80s when government was a very large part of the economy when it got to round about 43 to 44 percent. So in this world, the Conservatives may end up spending as much as Labor. Why is that important? Well, it's important because the whole of the global economy is looking at governments in Europe and in the US, particularly also Japan. See, they're going to be spending more. They're gonna be doing these fiscal packages where they spend money and they finance it through debt. If the UK conservatives win and the UK conservatives come out with a strong fiscal package, then the expectation would be that the winds of change are sweeping across the world and that other countries within Europe and in the US as well will also do much more fiscal spending. What does this mean for global assets? Well, this in theory, it should be inflationary. If you start to spend, then the risks that have currently been on the deflationary side of the equation moved to the inflationary side. They're going to spend and spend and spend. It means the bond yields potentially may start to move up. Now we look at the U.K. first, the U.K. bond yields, looking at the 10 year gilt versus the US 10 year yield on the Treasury. They're in lockstep pretty much 15 years. Then in 2016, around the Brexit vote, we saw a big divergence with the UK falling away from the US. US yields were above. If the Conservatives win, then you'd expect yields to push up relative to the US and that gap to close. So what this really means is that if the Conservatives do manage to hold onto their current lead in the polls and win a majority of the election and then come with a very strong fiscal pact package of more spending, then I think this is a clear indication that we are seeing a shift across the world away from the austerity measures towards fiscal expenditure, but perhaps fiscal expenditure on a scale not seen before. This is a move away from less government to the last 30 years to more government. It's potentially a shift away from lower inflation expectations to higher inflation expectations. It may be that we are moving away from the the decade of disinflation to warn of balanced inflation and maybe even the fear that we get much higher inflation in the near term as central banks, along with governments, move away from austerity towards much, much higher levels of spending and therefore much, much higher expectations of future inflation.
[00:07:01] 2019 has all been about the fears returning of deflation and disinflation. Yet here as we come into the end of the year there’s some chatter knocking around that perhaps we could be surprised by inflation to the upside and potentially a new breakout in gold. Now you’d have had to have been on a different planet to not notice bond yields plummeting. We saw bond yields in Germany at minus 75. We saw 17 trillion global debt with negative yields. And it hasn't ended there. We started to see things like the producer price indices. This is PPI, factory inflation for all intents and purposes, starting to roll over and confirm many of these deflationary fears. We've seen it in Europe. Just this last month its gone into negative territory. In China we've had three consecutive months. And normally when China's PPI goes negative, it stays there for anywhere between 1 and 4 years. We've also seen inflation expectations out to sort of 5 or 10 years hitting all time lows over the last few months. So why is it that people are starting to think that there might be a little bit of inflation or at least an inflationary surprise? The reason we get a surprise is because of positioning. If you're positioned to expect disinflation or deflation and then things swing the other way, even to a small extent, then that could have the impact of markets pricing inflation, even if it's only a marginal shift. And at the moment we have, in particular in the bond market, we've gone from extreme shorts to something close to neutral on two, five and ten year futures. We've also seen a very, very big shift from an extreme short in the three month euro dollar contract to an extreme long. Now, that has to be tempered with the fact that there is someone on the other side of these. But the speculative positions have moved very aggressively from short, expecting higher rates to record longs, expecting low rates. Gold itself had moved quite aggressively this year when nominal yields had been falling. So why would gold now breakouts on the reverse? And this is all down to real yields. And what is a real yield? Well, a real yield is the nominal yield or the absolute yield of a bond, which might be 2 percent, less inflation which might be one and a half percent. So your real yield is 50 basis points. Gold moves inversely with real yields. Where real yields go, gold goes in the opposite direction. So when those yields were collapsing through this year, those real yields were falling as well. Gold was going up. Now that we've seen those nominal yields moving a little bit higher, what we now need to see for gold is inflation. If inflation picks up and the inflation portion gets bigger, then the real yield will fall again, assuming that the overall level of yields is static. I think what's interesting here is that in the US, the CPI core, the consumer price index, has been banging against its effectively sort of five or six year highs. We've got certain US and European equity indices trying to price growth. The DAX, the German index has been breaking out. Taiwan and Korea are also trying to break out and gold as well as being a hedge against a collapse in yields and nominal yields everywhere going negative. It's also a hedge on the other side to inflation. And it might be that in this environment where we're seeing these yields still in a little bit of no man's territory, but with inflation in the US on the consumer level, potentially with the opportunity to break out and equity markets across the world, also hinting at a little bit of inflation coming into your end. Therefore, what might surprise us is that we get slightly more inflation than expected. Currently, we still expect disinflation to be the prevailing trend. But what we're seeing with these equity markets in Europe and Asia, what we're seeing with with gold trying to break out is that we could get a move on risk assets, which is pricing for inflation, inflation to the upside. Gold going for higher inflation rather than lower yields and equity markets that want to follow that lead from gold into year end, where inflation is the surprise package for the market.
[00:11:13] There's very clearly been a global slowdown which has been concentrated in those global open economies, particularly those with a strong manufacturing base and along the supply chains from China. You can see it in places like Japan and Korea where exports have fallen off a cliff over the last 12 months. The big question for a lot of people now is will it spread within Europe? Within Europe, we have seen weakness, but it's been concentrated mainly on Germany. In Germany, we've seen the PMI in recessionary territory for much of the last six months. But many people see this in some ways as a bit of payback. Payback because the German economy was very, very strong based on exports, based on manufacturing. And it's that supply chain which has been slowing down. The rest of Europe has been relatively unscathed. But there are concerns that it might spread. So what we look at to see if the issue that is currently German can become wider European issues. One country that is a great open economy within Europe outside the eurozone is Sweden. Sweden is an industrial manufacturer and export driven economy. Many of its exports go to Europe. If you get a slowdown within wider Europe, often Sweden will feel that weakness coming through its own economy. And we've seen already that the PMI has fallen below 50 two months ago. The reason the PMI is very interesting is because the PMI generally leads Europe by about two months. So if the PMI in Sweden declines, it's often with a two month lag that we see weakness returning to Europe. This month we saw that Swedish PMI sub 50 for the second month on the trot. And the other thing to watch for is the Swedish krona, because the Swedish krona has been a reasonable barometer of strength within Europe as well. Swedish krona generally is very weak ahead of a global recession or just a global slowdown. In fact, most of the slowdowns we've seen over the last 30 years have been preceded by a decent move of weakness in the Swedish krona. Currently it has been consolidating. This is the Swedish krona versus the dollar around about 9.6, 9.7. But if we get a move on the Swedish krona through 10, i.e. some significant weakening from here aligned with the PMIs in Sweden remaining below that 50 level, then that could suggest that the weakness that we've seen in Germany is not confined, but is going to spread to the wider European market and economy as well.