Tariff tangle

Trade threats and tech troubles have made investors nervous, but economies around the world remain healthy and relatively vibrant. Our chief investment officer, Julian Chillingworth, says markets are likely to remain rocky, but that should provide opportunities.

In a bid to protect Americans against the tyrannies of cheaper materials and consumer products, President Donald Trump levelled tens of billions of tariffs at China last month.

China responded with a proportionate amount of new tariffs on American goods and a warning that it didn’t want a trade war. Mr Trump on the other hand has welcomed an escalation of the trade dispute, saying it would help rebalance the Sino-American relationship. In reality, neither country would do well out of a sustained increase in protectionism. China’s appetite for foreign metals, hogs and services is voracious, while millions of US workers depend on cheap imported parts that go into much more valuable exports and muted American wage growth has been assuaged by low-priced foreign televisions, fridges and cars.

Stock markets have lurched around as the world’s largest markets trade new and wider tariffs. However, as with all things Trump, we are hesitant to take anything at face value. The tariffs aren’t set to go live till May at the earliest and throughout the debacle high-level figures of the Trump administration have been negotiating in China. There’s a good chance that this brinksmanship will end with some compromises on trade, but no new widespread barriers to trade. China will keep its most important end market, and Mr Trump can show his Main Street base that he went to bat for them. There’s still a large risk that this spirals out of hand and damages global growth. This uncertainty will continue to weigh on stock markets until it is satisfactorily resolved.

Facebook’s careless treatment of users’ private data, Uber’s first fatal crash with a self-driving car and the President’s angry tweets created a blizzard of bad publicity for the tech sector, which has been the predominant driver of US stock markets. By mid-March, the S&P 500 Information Technology Sector was up almost 12% for the year in dollar terms, before it slumped rapidly to post a quarterly return of just 3.2% (it was down 4.0% for the month).

For all the poor stock market and trade news, however, the US economy remains strong. The number of people signing on for unemployment benefits is easily the lowest since the 1970s, US core inflation has been steady at roughly 1.7-1.8% for almost a year and annualised GDP growth has been floating round 3% since mid-2017.

Source: FE Analytics, data sterling total return to 31 March

Bumpy road

The Bank of England has this year changed its forecast. It now expects to start hiking interest rates faster and higher than before to combat stubbornly high inflation. Oil prices are roughly stable between $65-70 and inflation fell to 2.7% in February. Meanwhile, GDP growth continues to decelerate, albeit at a healthier rate than originally expected. Derivative markets put an 86% probability on rates rising to 0.75% in May, and the 10-year gilt yield finished the quarter at 1.35%.

Meanwhile, dollar Libor, an interest rate used to benchmark trillions of dollars in loans and other transactions, has almost doubled since October. It’s difficult to know what’s behind this because there are so many factors that influence interest rates. However, we believe it may be driven by US companies trying to repatriate the hundreds of billions of dollars they have stashed offshore. Most of this cash has actually been invested in short-term corporate bonds – about 8% of all short-dated corporate bonds are held by the eight largest hoarders, according to Goldman Sachs. To take advantage of the amnesty allowed under the Trump tax reform, companies have to sell these bonds, and all that selling may be flowing through into the dollar LIBOR rate.

What’s important to us is the effect: short-term borrowing costs for US firms have increased drastically at a time when corporate debt is elevated. This reinforces our preference for companies with low levels of debt, as they will be less affected by this move in interest rates. This is just one of several factors pushing up companies’ cost of capital – the return that investors need to justify the risks of an investment. As this cost of capital creeps up, driven by higher debt payments and greater uncertainty, the share prices of lower-growth companies will be pushed down.

We think the remainder of 2018 will be as bumpy as the past few months, but we are optimistic about the state of the world economy and therefore the growth prospects for quality firms. Solid, reliable growth should attract investors in the long-run, regardless of today’s tweets or tomorrow’s headlines.

Bond yields

Source: Bloomberg

Julian Chillingworth, Chief Investment Officer