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A holiday gift for markets: Increased economic policy certainty

Two developments
last week suggest that we have entered a period of improved economic policy
certainty. Both the UK election and the US-China Phase 1 trade deal promise to
bring far more clarity for businesses as they plan for 2020 and beyond. If so,
this could be a welcome gift for the economy and the stock market as we enter
the holiday season.

A Jan. 31 Brexit looks
likely

Thanks
to a Conservative
Party landslide
in the Dec. 12 UK Parliamentary election, we expect Brexit can be completed by the end of January, but
trade negotiations on the future relationship of the UK and the European Union may
be stretched out beyond December 2020. At this point, it looks possible that the
UK may exit the EU’s single market (which allows for the free movement of goods
and services among the different countries in the EU), but remain in or align
with the customs union (which establishes a common system of tariffs and import
quotas for trading with non-members).

As the details
solidify, I would expect to see a gradual and sustained recovery in
investment and a reversion to a higher growth rate that is somewhere between
that of the eurozone and that of the US (even if it is slower than pre-Brexit
economic growth). If so, sterling is likely to consolidate some further gains,
but still at a discount to pre-Brexit levels. Gilt yields could move somewhat
higher still. Equities are likely to rise significantly. With uncertainty
easing, the Bank of England might even attempt to catch up to the global easing
frenzy with a rate cut. 

A Phase 1 trade deal could provide
significant benefits

The day after
the UK election, it was announced that the US and China have agreed on the
first phase of a trade deal — a development that I believe should be very
positive for a number of industries.

This Phase 1 deal
includes several items that could benefit US industries:

  • China
    has promised to ease pressure on US companies in terms of technology transfer,
    which should be very positive for the tech sector, if it comes to fruition.
  • The
    withdrawal of tariffs threatened to be imposed on Dec. 15 should also benefit
    US tech companies (laptops and cell phones would have been subject to those
    tariffs) as well as some US retailers (who would have had price increases on imported
    goods from China that they sell, from personal care products to clothing to
    household goods).
  • The
    agriculture, energy, and manufacturing industries should also benefit – if
    China does in fact purchase additional goods, as is currently part of the Phase
    1 deal.
  • The
    partial rollback of the September tariffs (from 15% to 7.5%) are also part of
    the current deal. That should benefit US retailers, given those tariffs were
    focused on consumer goods.

Going forward, the rollback of additional existing tariffs over time is expected as well – although this is far from certain. If these rollbacks were to occur, one likely beneficiary is the auto industry (US and German auto companies).

Overall, the
Phase 1 deal should be positive for business investment because it reduces
economic policy uncertainty, and increased business investment should benefit
the global economy. I expect this to create an upward bias for stocks globally
— especially for Chinese equities, which in my view have been unfairly beaten
down in the last several years.

Neither development is a ‘done deal’

While increased
certainty around Brexit and a Phase 1 US-China trade deal are both very
positive developments, nothing is a “done deal.”

  • There
    remains some uncertainty on the approach UK Prime Minister Boris Johnson will
    take going forward. Commentary over the weekend was divided on whether or not
    Johnson will soften his Brexit stance. Some argue he will because he is no
    longer beholden to the ERG (an alliance of pro-Brexit Conservative Members of
    Parliament) and Nigel Farage (leader of the Brexit Party). On the other hand, others
    argue he will want to stick to his promise of ending the transition period by the
    end of 2020).
  • The
    Phase 1 deal has not been signed, and there is still a possibility that the
    agreement in principle could be derailed:

    • China
      has thus far only confirmed a few details of the agreement — that it will
      increase its purchases of US goods but does not appear willing to meet specific
      quotas. It has not confirmed that it will ease technology transfer requirements
      that US companies have been subject to.
    • China
      is laser focused on getting the US to continue to roll back existing tariffs —
      and has made that an important condition of negotiations. However, the US has
      thus far been very reluctant to roll back tariffs without gaining any major
      concessions, so it is unclear whether it will give up any more ground than it
      already has.
    • While
      the US and China have come to a truce on tariffs, they appear to be engaged in
      other skirmishes. Last week, the Financial
      Times
      reported that China has ordered its government offices to remove
      foreign computer equipment and software within three years, replacing it with
      Chinese equipment and software. This would negatively impact US tech companies
      that supply such goods to China. This appears to be in retaliation for a recent
      directive by the Trump administration to curb the use of Chinese technology by
      the US. Large-scale replacement of US equipment by China is expected to begin
      next year, suggesting the relationship between the two countries remains tense
      and there is a real risk that it could deteriorate and possibly negatively
      impact trade negotiations.

In conclusion, last
week’s developments are very positive. However, until Brexit is completed and a
Phase 1 trade deal is signed, there is the potential that uncertainty could spike
again. In our view, this means that while maintaining a diversified portfolio
with adequate exposure to risk assets is important, it’s also critical to plan
for the potential for higher volatility in the short term.

Happy holidays

In celebration
of the holiday season, Weekly Market Compass will not publish for the last two
weeks of the year. We’ll be back on Jan. 6. Happy Holidays to you and yours!

Important
Information

Blog header image:
Zelma Brezinska / EyeEm / Getty

All investing
involves risk, including the risk of loss.

Diversification
does not guarantee a profit or eliminate the risk of loss.

Brexit refers to
the scheduled exit of the UK from the European Union.

UK gilts are bonds
issued by the British government.

The opinions
referenced above are those of the author as of Dec. 16, 2019. These comments should not be
construed as recommendations, but as an illustration of broader themes.
Forward-looking statements are not guarantees of future results. They involve
risks, uncertainties and assumptions; there can be no assurance that actual
results will not differ materially from expectations.

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